(Lok Sang Ho (Auth.) ) Principles of Public Policy

PRINCIPLES OF PUBLIC POLICY PRACTICE
ABOUT THE AUTHOR
Professor Lok Sang Ho, Director of the Center for Public Policy Studies
and Professor of Economics, Lingnan University, has a long-standing
interest in public policy. With a doctorate in economics from the
University of Toronto, he started his career of policy research in the
Ontario Ministry of Treasury and Economics as Economist and then as
Research Officer at the Ontario Economic Council. Prior to his
appointment at Lingnan University in 1995, Professor Ho was Senior
Lecturer at the Chinese University of Hong Kong. Professor Ho remains
affiliated with the Chinese University as an Honorary Research Fellow.
He has sat in a number of government and public advisory bodies. The
list includes the Central Policy Unit of the Hong Kong Special
Administrative Region Government, the Pacific Economic Cooperation
Council Hong Kong Committee, the Trade Policy Forum, and the
committee of advisors for the Hong Kong Institute of Monetary Research
of the Hong Kong Monetary Authority. Professor Ho has been President
of Hong Kong Economic Council since 1999 and Managing Editor of the
Pacific Economic Review since 1996.
PRINCIPLES OF
PUBLIC POLICY PRACTICE
by
LokSangHo
Center for Public Policy Studies
Lingnan University, Hong Kong
Foreword by Yew-Kwang Ng
"
~.
SPRINGER SCIENCE+BUSINESS MEDIA, LLC
Library of Congress Cataloging-in-Publication Data

Ho, Lok-sang.
Principles of public policy practice / by Lok Sang Ho; foreword by Yew-Kwang Ng.
p.cm.
Includes bibliographical references (p.) and index.
ISBN 978-1-4613-5622-6
ISBN 978-1-4615-1575-3 (eBook)
DOI 10.1007/978-1-4615-1575-3
1. Public adminstrataion--Philosophy. 2. Economic Policy--Philosophy. 3. Risk
management.
JFI351.H592001
320' .6'01--dc21
00-048692
Copyright 2001 by Springer Science+Business Media New York

Originally published by Kluwer Academic Publishers in 2001
Softcover reprint of the hardcover lst edition 2001
AII rights reserved. No part of this publication may be reproduced, stored in a retrieval
system or transmitted in any form or by any means, mechanical, photo-copying, recording,
or otherwise, without the prior written permission of the publisher, Springer Science
+Business Media, LLC.
Printed on acid-free paper.
To Alvin, Emily, and Irene

Would I be wise;
Would the World learn.
CONTENTS
Foreword
Preface
Acknowledgments
ix
xv
xvii
1
Chapter 1
Introduction
Part I
Chapter 2
Chapter 3
Chapter 4
The Theory of Public Policy Design

What Makes Good Public Policy
Human Nature and Public Policy
Institutional Foundations for a Just Society
7
9
19
37
Part 2
Chapter 5
Microeconomic Risk Management

Health Care Delivery and Financing: In Search of an Ideal
Model
Legal Aid and Justice
Bank Deposit Insurance
Towards an Optimal Public Pension Scheme
57
Chapter 6
Chapter 7
Chapter 8
59
71
77
87
Part 3
Macroeconomic Risk Management
Chapter 9 The Risks of Monetary Crises: Inflation
Chapter 10 The Risks of Monetary Crises: Currency Crises and Interest
Rate Gyrations
Chapter 11 Savings Instruments, Bubbles, and Financial Crises
Chapter 12 Transparency
109
117
129
Part 4
Chapter
Chapter
Chapter
Chapter
133
135
143
153
163
13
14
15
16
Resource Allocation and Redistribution

Optimal Size of the Government
Education Policy
Housing (with a Digression on Transportation Pricing)
Social Safety Net and Redistribution
99
101
Part 5
Public Policy and Economic Ecology
171
Chapter 17 Economic Ecology: The Case of the Great Depression of the
173
Nineteen Thirties
Chapter 18 Economic Ecology: The Case of Hong Kong
183
Vlll
Epilogue
Chapter 19 Public Policy in the New Millennium
References
Index
199
201
211
219
FOREWORD
It is a pleasure to read this well-written book and an honor to write the

foreword.
The breadth of coverage of this book is phenomenal. Apart from the
general principles of public policy design discussed in Part I, it covers the
micro economic problems like education, health care, housing, legal aid, and
social security as well as the macroeconomic problems like inflation,
exchange rates, and financial crises. It also ranges from the efficiency issues
to the distributive issues. I admire Professor Ho' s ability to tackle such a
wide range of issues. Also, I am more confident dealing with the ultimate
principles for public policy in general. Practical issues are more diverse and
involve many aspects with conflicting considerations. Thus, we have the
joke about the government's dislike for economists with two hands. This
consideration makes me admire even more the ability and courage of Ho.
Moreover, while I expect few readers to have complete agreement with Ho
on all issues discussed in this book, I am confident that most readers will
find, as I have, many enlightening discussions and thought-provoking ideas.
Thus, I have no hesitation in recommending this book to readers.
I find some of the proposals courageous, even provocative, and
perhaps outrageous to some. For example, many readers may find the
suggestion of corporal punishment of criminals (Ch. 4) barbaric. I strongly
suggest that such readers should carefully consider the arguments put forth
by Ho. Personally, I sympathize with such readers. The very mental image of
corporal punishment may be disgusting. It would be much better if more
'civilized' methods like imprisonment may achieve the same purpose
without even more undesirable effects. Corporal punishment may also be
counter-productive in cases. However, on balance, I am convinced by Ho's
argument that imprisonment is worse than corporal punishment. I prefer the
use of fines as far as possible. If either corporal punishment or imprisonment
is needed, I will side with Ho in opting for the former. In particular,
imprisonment imposes higher costs on innocent people, particularly the
family members of the convicts. If a person is convicted of a crime, why
should the innocent spouse, children, and possibly parents suffer the very
serious damage of long separation? They may be dependent on the convict
for financial and personal care and love. In many cases, it is these innocent
people who suffer more from the imprisonment than the convict himself.
While corporal punishment may also impose damage on family members,

the magnitude is certainly smaller than that of imprisonment in most cases.
By concentrating damage on the convict, corporal punishment is much fairer
than imprisonment. Moreover, as Ho convincingly argues, imprisonment is
likely to cause much more differences in damages on different persons even
from the viewpoint of the convicts themselves. The dislike of corporal
punishment is usually based more on the very superficial emotion triggered
by the vivid mental image than on the cool analysis of justice. Ho' s proposal
deserves serious attention. (His proposals on education policy in Chapter 14
also merit close examination.)
Another provocative proposal is that of a 100% inheritance tax, which
he recommended as socially desirable and just when the government is in the
position to support the education and the basic living expenses of children
(Ch. 4). An economist is likely to disagree with the desirability of such a
drastic measure, believing that the inefficiency of discouraging savings and
distorting choices may be too high. While such inefficiencies have to be
taken into account, economists tend to ignore another type of inefficiency rich parents tend to give too much inheritance to children to their
disadvantage in terms of happiness if not in terms of money. Having too
much money to start with is usually corrosive of one's characters and bad for
self-reliance and personal development. Also, the prevalence of relativeincome effects (on which Frank, 1999, is a highly recommended reading)
may mean that most of us are over-working from the viewpoint of social
optimality, and some discouragement through a 100% inheritance tax may
really be desirable. Perhaps a compromise that provides a basic exemption
and a sliding scale of tax-rates fast approaching 100% may be desirable.
Also, it may be desirable to combine with Meade's (1964) suggestion that
the rate of tax should not be a function of the size of the estate of the
deceased but a function of the size of the total assets inclusive of the
bequeathed amount of the recipient.
On health care (Chapter 5), Ho proposed an annual spending limit of
about 6% of the mean household income for a household of average size,
over which society will reimburse all the medical expenditures. I suggest an
improvement upon this proposal by replacing the single limit separating full
self-payment with full reimbursement with at least two limits separating full
self-payment, part self-payment (i.e. part reimbursement), and full
reimbursement to increase the range where individuals still have some
incentives to economize on medical expenditures.
In his discussion of financial crises in Chapter 11, Ho proposes the
issue of bonds denominated in the 'World Currency Unit' (defined by a
composite output consisting of the US, Euro, Japanese, Canadian, and
Australian GDPs in some base year). Such bonds are argued to be effective
Foreword
xi
in avoiding financial crises as savers who need an inflation hedge can buy
these bonds rather than properties and stocks, creating bubbles in these
markets. To have a more complete discussion, Ho should go on to discuss
what happen to the funds the issuers of these bonds obtain from investors.
Might they use them to buy properties and stocks, especially in a climate
when the general investors would have found it attractive to buy properties
and stocks?
When first reading through Chapters 2 and 3, my first reaction was that
many of the propositions may be debatable or insufficiently justified.
However, I found it difficult to fault most propositions after further thoughts.
For example, under Proposition 1 in Chapter 3, Ho says that 'all human
beings have the same true utility (happiness) function.' I first inclined to
disagree. Then I realized that if all factors explaining personal differences
are put as elements in the function, then we may at least in principle make it
the same function.
I do have differences with Ho. In his discussion of human nature in
Chapter 3, Ho makes the distinction that 'happiness is the state of total wellbeing whereas utilitarian utility is the summation of the balance of pleasures
over pains.' I regard my happiness (or welfare) as, by definition, the same as
my total well-being and is measured by the summation (or integration) of the
balance of pleasures over pains, taking a wide definition to include both the
sensuous, the spiritual, etc. I use utility to represent preference which may
differ from happiness due to ignorance, a concern for the welfare of others,
and irrationality.
To justify his distinction, Ho gives an example of a person of high
summation of the balance of pleasures over pains but of low total well-being.
'A person who has never had any experience of pain in any form will not be
able to communicate with other fellow men and may not be able to
experience or appreciate such human experiences and qualities as love,
courage, and will power. Such a person would be the loneliest person on
earth.' I quite agree that the experience of pain may have some positive
effects like the training of will power. However, Ho's example fails to make
me see his distinction. If the person has low total well-being because of
loneliness and lack of communication, then his summation of the balance of
pleasures over pains must also be low, since these pleasures and pains should
include the effects of loneliness and failure to appreciate love, etc.
Ho also explains (in Proposition 7 of Chapter 3) that 'Spiritual
happiness is derived from going through and reflecting upon the ups and
downs in life. Spiritual happiness is based on a sensitivity to the joys and
sorrows of other human beings and an inner harmony achieved through the
resolution of inner conflicts.' I also allow the happiness of others to affect
one's happiness and allow one to choose to increase the happiness of others,
XlI
even at a cost of lowering one's own happiness. (See Ng 2000, ChA.)

However, I see no need to distinguish total well-being from the balance of
pleasures over pains. (For a compelling axiomatic argument that happiness
or total well-being is properly measured by the integration of the balance of
pleasures and pains, see Kahneman, et al. 1997.)
Ho is strongly in favor of the Harsanyi-Rawls construct of the veil of
ignorance which I also find ingenious. However, while Harsanyi
convincingly deduces the utilitarian social welfare function (maximizing the
equally weighted sum of individual welfares) from this construct, Rawls
mysteriously obtains an almost opposite conclusion of maximizing the
welfare of the worst-off person. Ho has not discussed this obvious contrast
between Harsanyi and Rawls. In my view, at least at the fundamental level
of ultimate social objective, Harsanyi is obviously right. (Recent queries on
the validity of Harsanyi's arguments have been answered in Ng 1999.) Some
people use risk aversion to explain Rawls' conclusion. However, while it is
rational to be risk averse with respect to income due to diminishing marginal
utility of income, it is not rational to be risk averse with respect to
utility/welfare, as one cannot have diminishing marginal utility of utility (Ng
1984). Moreover, even accepting the rationality of being risk averse with
respect to utility/welfare, one still need an infinite degree of risk aversion to
have Rawls' extreme result. I do not believe that an infinite degree of risk
aversion is rationally possible.
On a more specific point, both the expected utility hypothesis
(Proposition 12 in Chapter 3) and my 1984 argument on the rationality of
expected subjective utility maximization (middle of Chapter 3) are criticized
as ignoring the ex ante disutility of fear and uncertainty of risky prospects. In
the presence of such 'mental bads,' we have to construct more complicated
choice alternatives. However, the ultimate rationality of expected subjective
utility maximization is not affected.
In conclusion, I reaffirm that I have benefited from reading this book
and believe that many of his courageous proposals are thought-provoking
and merit close attention.
Yew-Kwang Ng
Dept. of Economics, Monash University
Foreword
xiii
REFERENCES
Frank, Robert H. (1999) Luxury Fever: Why Money Fails to Satisfo in an Era of Excess, New
York: The Free Press.
Kahneman, Daniel, Peter P. Wakker, and Rakesh Sarin (1997) "Back to Bentham?
Explorations of Experienced Utility", Quarterly Journal of Economics, 112:2, May,
375-405.
Meade, James E. (1964) Efficiency, Equality, and the Ownership of Property, London: Allen
& Unwin.
Ng, Yew-Kwang (1984) "Expected Subjective Utility: Is the Neumann-Morgenstern Utility
the Same as the Neoclassical's?" Social Choice and Welfare, 177-186; reprinted in Ng
(1990).
Ng, Yew-Kwang (1990) Social Welfare and Economic Policy, Heme! Hempstead,
Hertfordshire, U.K.: Harvester Wheatsheaf.
Ng, Yew-Kwang (1999) "Utility, Informed Preference, or Happiness?", Social Choice and
Welfare, 16:2, 197-216.
Ng, Yew-Kwang (2000) Efficiency, Equality, and Public Policy: With a Case for Higher
Public Spending, Basingstoke, Hampshire: Macmillan.
PREFACE
This book is written for those who are interested in the practice of
public policy. Two main themes pervade the entire book. The first is that
the foremost task facing policy makers is to anticipate the problems that may
arise and to set up the elements of policy which will deal with or avoid those
problems in a way that will serve the interest of the "the representative
individual" best. In technical parlance, we say that public policy is
designed to maximize the ex ante welfare of the representative individual.
This is not quite the same as maximizing "expected utility" or expected
welfare. In a world with different possible states of the world that can
occur, expected utility may be defined as the mathematical expectation of
the various utility levels that would be realized under different states of the
world, the probabilities of occurrence of which being assumed to be known.
The distinction is best illustrated by a society made up of individuals
all of whom want to subscribe to an insurance plan to protect them from a
risk which is expected to hit one of them randomly in the upcoming period.
Because everyone prefers having the insurance plan to not having one, the
insurance plan, by definition, enhances ex ante welfare for everyone. Ex
post, the one hit with misfortune, receiving compensation, becomes better
off than otherwise, while all others, who contribute to the insurance plan but
get nothing back, become worse off than otherwise.
In speaking for "the representative individual," this book implores that
policy makers try to forget about their own identities and those of others.
Their job is to work out a policy that they feel most comfortable with,
imagining that they could fall into the shoes of any of the real persons who
constitute the society.
It is the belief of the author that social scientists have spent too much
time working on conflict resolution and finding out whether "social welfare"
is higher or lower when there are both losers and gainers. Clearly conflict
resolution is a real and important subject. In practice, however, conflict
resolution is sorted out through the political process-regardless of what
social scientists think. Although consensus has seldom been the hallmark of
public policy, now is the time to ponder an alternative to the often thankless
task of conflict resolution. Considering the welfare of the representative
individual-assuming that everyone has an equal chance to be everyone else
xvi
while designing public policy-will allow us to look for a new consensus,
and will contribute to a more stable, happier society.
The second theme of the book is the importance of the "systems
The human
perspective" in the design and consideration of public policy.
being is a bio-psychological and economic system, with complicated inputoutput and production-consumption relationships. The socio-economic
system is an ecological "general equilibrium" system, with each component
related and dependent on other components in ways which we do not fully
understand. The systems perspective will help us avoid terrible policy
mistakes and enhance the chances of success.
Understanding human nature, working with human nature, and meeting
the needs of human nature should then be the preoccupation of policy
makers.
To do this effectively, policy makers must also understand the
socio-economic system, its dynamics, and its ecological relationships. It is
hoped that this book has provided a good starting point in illuminating what
may be called the principles of public policy practice, which must be
grounded on such understanding.
Lok Sang Ho
Lingnan University
September 2000
ACKNOWLEDGMENTS
I would like to thank, in particular, Prof. Yew-Kwang Ng of Monash

University and Prof. David Weimer of the University of Wisconsin, Madison,
for carefully reading through the manuscript and valuable suggestions. I
benefited much from the intellectual stimulation that Prof. Ng offered and
from Prof. Weimer's meticulous guidance and encouragement from the
initiation of the project through its completion. Prof. Barton Starr of
Lingnan University kindly read Chapter 17 and made valuable suggestions.
Naturally remaining errors are entirely my own.
Gary Wong and Wilson Tang have contributed valuable research
assistance during the course of the project. Dorothy Kok offered excellent
help in typesetting and reorganizing the manuscript.
Financial support from Lingnan University is gratefully acknowledged.
I would also like to express thanks to the Hong Kong Institute of
Bankers, JAI PresslNorth Holland, the Western Economic Association,
Kluwer Academic Publishers, the MCB Press, the Hong Kong Economic
Association, and Blackwell Publishers for using materials previously
published, sometimes extensively. Thanks are also due to Allard Winterink
of Kluwer Academic Publishers for facilitating the publication process in the
most efficient manner.
Chapter 1
INTRODUCTION
1. DEMOCRATIC INSTITUTIONS, "SUBSTANTIVE

DEMOCRACY," AND POLICY
Governments affect human welfare in at least four ways. They do so
by providing more or less of the goods and services that are complementary
to private production and consumption. They may obstruct or tax private
sector production and consumption. They may limit the freedom to access
the goods and services that are otherwise available in the market. They
may redistribute income and wealth.
Governments can serve "the public interest," however interpreted.
Governments can, however, also inadvertently hurt the public interest.
They can even be "predatory" in nature-that is, they can tax the private
sector for the benefit of the powerful people in the government, as discussed
in Young and Marcouiller (1995). This book, however, assumes that
governments serve the people and the public interest. Based on this
assumption, I shall demonstrate some principles of public policy practice
that should be useful to policy makers as well as all those who are concerned
with the quality of public policy.
While governments are supposed to serve the public interest,
government bureaucrats are not saints. Given the opportunity and the
inducements, some individuals are susceptible to corruption. They need to
be prevented by certain institutional constraints from taking advantage of the
power that they wield at the expense of the public.
Institutional
arrangements that protect the private sector from harassment by government
officials are favorable to economic development. A free press, an
independent ombudsman installed with authority, a "commissioner for
administrative complaints," an "independent commISSIon against
corruption," etc., are part of an institutional framework that can serve this
purpose. Democratic institutions, in particular a representative government,
may also serve the purpose. In practice, however, formal democratic
institutions per se-electoral politics and party politics-do not have a better
performance record than the other mechanisms mentioned above to combat
Principles of Public Policy Practice
predatory behaviour by the state. They are neither a necessary nor a

sufficient condition for what I call "substantive democracy"-governments
which are truly responsive to and meet the needs of the public.
"Non-predatory" governments-governments that set out to serve
rather than to extract from the people-may contribute more or less to
welfare. That depends on whether it is efficient and whether it adopts the
right policies.
There are two kinds of things that governments do. The first kind has to
do with the welfare of the entire society. The second kind has to do with
redistribution. Government activities that improve the social capital or
infrastructure and thus help expand production and consumption and reduce
risks and uncertainty belong to the first kind. Government activities that
cater to the welfare of selected target groups belong to the second kind.
It is my contention that an "economically friendly" constitution,
enshrined by popular support and protected by a free press, an independent
judiciary and legal process, and a bureaucracy accountable to the people, are
the best means to ensure that governments do the right things to promote the
social good--certainly a far better guarantee than democratic institutions
narrowly interpreted as universal suffrage and an elected government.
The main contribution of democratic institutions to economic
development is to provide smooth transfer of leadership, so that society is
not destabilised by a scramble for power, which had been the single most
destabilizing force to China's economic development since the inauguration
of the Peoples' Republic of China on October 1 1949. Political upheavals
in China had cost tens of millions of lives, had disrupted productive
activities, and had driven hundreds of thousands out of the country as illegal
emigrants. Only when China found a strong leader, namely Deng Xiaoping, who put economic development and stability ahead of everything else,
was China spared of more power struggles from 1979 to 1989. The
Tiananmen incident of 1989, however, showed once again the potential
horrors of power struggle in the absence of a democratic process for transfer
of power.
Democratic institutions are, however, neither a necessary nor a
sufficient condition to protect property rights, to enforce contracts, to
provide adequate infrastructure, or to provide a stable macroeconomic
environment. All of these functions are necessary regardless of who is in
power, if the economy is to flourish. There is no room for a democratically
elected government to alter this basic mission. On the other hand, any
government that is effective in delivering these public goods is like a
producer that responds to consumers' needs and abides by "the consumers'
sovereignty."l We can describe such a government as "substantively
democratic" even though it may not be "formally democratic."
Introduction
My second contention is that the modern day democratic process is

more often than not used by various sectarian or partisan interests for
redistribution purposes. The democratic process has been the avenue
through which various business, labor, and social groups further their narrow
interests. The pursuit of private, conflicting, interests through the political
process is often disruptive to economic development. It should be minimized
and restrained.
While an effective, "economically friendly" constitution (written or
implicit) and a bureaucracy disciplined to support such a constitution are a
boon to economic development, they are generally not considered to be the
substance of democracy. During the colonial days Hong Kong (since 1972)
had an Independent Commission Against Corruption and a Commissioner
for Administrative Complaints, and the Public Accounts Committee of the
Legislative Council was charged with the responsibility of examining and
reporting on reports prepared by the Director of Audit. But Hong Kong
was certainly not a democracy in the formal sense. In China, steps have
been taken to make the bureaucracy accountable to the people, but the PRC
does not tolerate an effective political opposition. None of its leaders
derived his mandate from the popular vote. It is clearly undemocratic. In
Korea when the military took over the government in 1961 it revamped the
bureaucracy to support President Park Chung Hee's economic program ("the
economically friendly constitution") that sought to provide the institutional
and physical infrastructure for development. The economic development
that unfolded, both in China and in Korea, is testimony that the lack of
democratic institutions does not in itself inhibit economic progress.
India has practised democracy for quite some time, but for years its
market institutions had been underdeveloped.
Only recently has it
liberalised its policy for foreign investment and embarked on bolder
economic reform.
Political scientists are also well aware of the danger posed by "the
tyranny of the majority" and seek to protect minority interest with a
constitution. Economists are also well aware of the possibility of "the
tyranny of the minority." It is recognized in the economics profession that
disperse interest groups are often under-represented in the democratic
process, because costs are concentrated among the activities while the
benefits are dispersed. In contrast, narrow interest groups stand to capture
most of the gains achieved by their political activities. Consequently the
silent majority often suffer. Over the years, their interest has been eroded
by various tax concessions granted at different times to pacify the narrow
interest groups. Protectionism is the most glaring example whereby
consumers at large suffer while much smaller groups gain.
Principles ofPublic Policy Practice
These sentiments of mine are shared by Robert Barro. Barro found the
US insistence on promoting democracy-sometimes ignoring the sacrifice in
terms of the rule of law~ubious. "China was continually attacked for its
lack of democracy, although it had made major strides in enhancing the rule of
law, whereas Russia was applauded for its free elections despite its difficulties
in maintaining law and order." (Barro, 2000, p.8) Commenting on US efforts
to promote democracy among developing countries, Barro concluded: "If there
is a limited amount of energy that can be used to accomplish institutional
reforms, then it is much better spent in a poor country by attempting to
implement the rule oflaw-or more generally, property rights and free markets.
These institutional features are the ones that matter most for economic growth,
and these features are not the same thing as (formal) democracy." (p.9)
The economic success of the four little dragons or "tigers": Korea,
Taiwan, Hong Kong, and Singapore in the past thirty years, has not been
predicated on the existence of democracy. The spectacular take-off of the
Chinese economy since 1979 is, likewise, not based on the existence of a
democratic government. Yet common to all of these success stories are the
prevalence or the emergence of the market system, the existence or the
emergence of the rule of law so that contracts are enforceable and property
rights are respected, a government that is intent to supply adequate
infrastructure and educate and train its labor force, and relative social and
political stability.
Concomitantly, if we cast our eyes on the economic stagnant
economies such as those found in Africa, we find that they often lack basic
market institutions, are marked by social and political instability, poor
infrastructure, and the absence of the rule of law caused by rampant
corruption. Some of these countries are formal democracies. The existence
of democratic process, then, is insufficient to result in an effective
government that can provide the crucial government services that are
complementary to private sector activity.
In typical democratic states, various factions in society try to use the
political process to gain an edge over others. This happened in the United
States, Germany, France, among others in the league of industrial nations,
and in India and various African states among the less developed countries.
Depending on the extent of strife, these political manoeuvring can have
potentially damaging economic consequences. Higher taxes may be needed
to fund expenditures that benefit special groups. Protectionist regulations
and special tax favors benefit one industry at the expense of others. Barriers
to trade damage economic efficiency.
Elected or otherwise, governments have to do two kinds of things: first
to promote the common good and second to balance the interests of diverse
groups. Before the advent of modern day economics people may not know
Introduction
what are the ingredients of good government, and they may either place their
bets on a dictator or on the arbitrary outcome of the democratic process.
Nowadays we know the ingredients of good government: provision of
adequate infrastructure, upholding the rule of law and fair play in the market
place, ensuring public order and social stability, providing a stable
macroeconomic environment. No matter which party takes power, it has to
work in these areas, and the bureaucracy-not political parties-should be
relied upon to deliver these needed governmental services. Different parties,
of course, may balance the interests of diverse groups in somewhat different
ways, but minor balancing acts should not have a material effect on
economic development as long as the common good is put on the top of the
agenda ahead of the minor balancing. The public should be educated to hold
their governments responsible for the delivery of the key government
servIces.
2. THE CENTRAL FOCUS OF THIS BOOK

This book is about public policy. There are currently tens of dozens. of
books on public policy. However, the focus of this book is on the practical
principles of public policy. The theory of public policy will be discussed only
in so far as it is of help to policy makers and the public in arriving at more
intelligent policy decisions. It is important that practices of public policy are
sound. This means that they must have a solid theoretical basis. Misguided
policy, those that bring misfortune to many people, are usually based on
misunderstandings about human nature, about how the different components of
the economy hang together, and about the dynamics of collective behavior. It
is the knowledge that misguided policy has ruined the lives of many people that
motivated the current book. Numerous examples drawn from different
countries will be used to illustrate this fundamental point.
Public policy practice is always about choice. It is the role of policy
analysts to work out alternative choices about policy design, and it is the role of
policy analysts to spell out the implications of alternative choices, so that
decision makers can do so in an informed manner. Policy analysts also need
to work out the mechanisms whereby the aspirations of the public can translate
into decisions and eventually translate into desirable policy outcomes.
Only theories having to do with decision making and public choice are
relevant. There are several kinds of such theories. First is theories about
human nature. We need to understand human nature in order to work out
policy designs and make the right choice. Second is theories about policy
designs. Different policy designs have different distributional consequences,
different consequences on peoples' incentives and behavior, and different
implications about risk. Third is theories about public choice mechanisms.

Making the assumption that human beings share many similar aspirationsaspirations to be free, to be protected from major disasters, and to realize
one's own life potential, I propose to see public choice mechanisms NOT as
a balancing act about different people's gains and losses. The public choice
problem is not to be resolved by adopting the Hicksian criterion, which says
that a change is desirable as long as the losers cannot bribe the gainers into
forfeiting the change. It is also not to be resolved by adopting the
Kaldorian criterion, which says that a change is desirable if the gainers can
compensate the losers. The public choice problem is, rather, to be seen as
one of trying to find out what will maximize ex ante welfare for everybody,
when no one knows in whose shoes one will fall. Rather than saying A
should be a slave to serve B because A's loss is smaller than B's gain (or
vice versa), we will argue it is far better not to make anyone a slave. Both
A and B will feel better off if they feel assured that none of them will ever be
made a slave. These ideas will be further explored in the rest of this book.
I intend that this book will be of practical value to policy makers and to
citizens interested in shaping the course of public policy making. I shall use
plenty of real life examples to illustrate my points. The subjects covered will
be broad. They include macroeconomic policy, international monetary
economics, labor market policy, health policy, housing, transportation, social
security, crime and punishment, education, and banking and finance. While
the areas look diverse, readers should find the arguments intelligible and should
find that the same themes about policy design and decision making
mechanisms recur again and again.
NOTES
Consumers' sovereignty refers to the operation of market force that directs producers
of goods and services to produce to meet the demands of consumers.
Part 1
THE THEORY OF PUBLIC POLICY DESIGN
Public policy should further the public interest. "The public interest,"
however, must not be divorced from the private interest of you and me.
Indeed it is the private interest of you and me and her/him that constitute the
public interest. While the private interests of different individuals may and
do conflict, policy makers should try to be impartial-should try to
maximize the ex ante welfare of "the representative individual," who is the
embodiment of you and me and her/him-with the aspirations and concerns
that are common to all of us.
Public policy should be designed with a keen awareness of human
nature, particularly the common concerns and worries of those served by the
policy. Ifpossible we should spell out the key policy parameters that affect
peoples' lives and confront the public with the consequences of the
alternative options. We should solicit public participation in the choice of
such parameters.
As Chapter 2 argues, public policy should take cognizance of the
hierarchy of policy goals and should take human nature as a constraint.
One central aspect of human nature is aversion to extreme risks.
Another aspect is that human beings make choices on the basis of their
perceptions. Chapter 3 notes that these perceptions are imperfect and are
subject to change. Public policy design should be keenly aware of the
dynamics of perception changes and should alleviate the worries about
extreme risks.
The subject of risks and how to handle them will be taken up further in
Chapter 4. We will explore the institutional foundations of a just society.
We will use various examples to show how policy can improve or reduce
human welfare depending on the way it handles risks.
Chapter 2
WHAT MAKES GOOD PUBLIC POLICY
The design of public policy must take full consideration of human

nature. Understanding the propensities, fears, and worries of the human
mind allows us to know how we should order policy objectives. It also
allows us to design our policies in a way that anticipates response, so we
will have a better idea of their effects.
Once human nature is seen in the proper light and the multiple needs
of society are recognized, it is not difficult to see the logic of a hierarchy of
policy objectives with some being treated as constraints and others as
objectives to be pursued as far as possible. Optimal public policy making
would treat basic policy objectives as given constraints in the short term but
the constraints themselves are also subject to revision over the longer term.
Public policy analysts will have done a great service if they can lay bare the
trade-off among conflicting policy goals and the relationship between policy
choice parameters and policy target variables.
1. INTRODUCTION
Policies are designed and implemented for specific purposes, but they
are always made in the context of human societies, subject to the constraints
of human nature, values prevailing in society, and the political reality. In
democratic societies policies are often introduced as a response to political
pressures, although sometimes they may represent a conscious attempt at
problem solving or as a means to achieve specific ends.
The fact that public policies are subject to political pressures is not a
problem. Indeed, the political process is needed to translate the aspirations
and needs of the community into actual policy choices, otherwise policy
choices would be made in a vacuum. However, it is of vital importance
that people taking part in the political process should know what they are
doing, particularly the implications of various policy decisions on the society
at large. To facilitate the process of informed public choice policy analysts
must spell out, as accurately and as explicitly as possible, the constraints that
the community faces and the trade-off implicit in various policy decisions.
10
It is highly desirable that the alternative policy designs provide key choice
parameters so that by adjusting these parameters different outcomes can
result, because the public debate then can focus on the suitable value of these
parameters.
The next section will discuss the constraint of human nature. This
will be followed by a discussion on the range of policy objectives. There is
a hierarchy of policy goals and it is important to assign some policy goals as
constraints (i.e., they are so basic that they cannot be compromised) and
others as objects for maximization (i.e., they are to be achieved as far as
possible). We will then make the case that the concept of optimality is
generally applicable to all kinds of policies and that costs and benefits are
also very general concepts that can cover economic, social, as well as
political, and moral as well as non-moral aspects. Finally, the concluding
section will explore the various dimensions of optimality.
2. THE CONSTRAINT OF HUMAN NATURE

Policies interact with human beings living in a social context to
produce different results. The design of policy must therefore take full
recognition of the inherent propensities and weaknesses of human nature.
Economists assume that human beings try to maximize "utility."
Regardless of what is meant by utility, it is in the nature of human beings
that they respond to incentives. They assess the situation, weigh the
various options, and attempt to make choices that they believe they will lead
to the most favorable results from their standpoints. They may of course
make mistakes, but they will learn. An important aspect about human
nature is that people share similar aspirations and fears.
Policy makers must recognize that the public will learn. The famous
"Lucas critique," which says essentially that macroeconomic policies that do
not take account of the behavioral response of people are ill-founded (Lucas,
1976), is a direct application and illustration of this concept. There are also
plenty of examples from the realm of social policy which equally forcefully
demonstrate the same principle. Thus, in the U.S., it was found that
policies intended to help single parent families financially turned out to
create single parent families. 1 Policy makers have now also learnt that
unemployment insurance always increases unemployment. In order to
design policies that fully take into account the behavioral response of the
affected groups we need to know more about human nature. Thus a good
knowledge of human nature is really fundamental to the design of effective
policies. Chapter 3 will be devoted to a discussion of human nature.
11
Proposition 1
The design of policies should take full account of the interaction
between behavior and the policies, and must recognize the fact that
individuals will respond to incentives.
Policies always produce a myriad of different effects, and there are
always multiple policy goals. It is very often the case that the policy goals
conflict among themselves. Economists sometimes simplify the problem
confronting policy makers with a conceptual framework called the social
welfare function. Once the social welfare function is defined, the policy
problem can then be described simply as choosing the policy instrument and
the values of policy parameters so as to maximize the social welfare function.
In practice, unfortunately, the social welfare function does not exist
objectively and there is no scientific way to gauge neither the form nor the
parameters of the social welfare function. The neatness of the social
welfare function belies and stands in sharp contrast with the complexity of
real world policy problems.
For policy makers and for the public who want a direction or guidance
in coming up with better policy choices discussions about the social welfare
function go no where. Instead, what we need are mechanisms and
considerations that can allow us to translate the similar-aspirations of the
different segments of the society into policy choices. This process should
involve some form of public participation, but the participation should not be
a "rent-seeking,,2 process or based on self-aggrandizement. Society needs
to know what choice parameters are open and how different choices of these
parameters impact on the various policy goals (Ro, 1997a). In the end no
social scientist should make decisions for society, which must make the
policy decisions collectively. We know that there will never be a
consensus over the details of the final choice to be made and we should not
attempt to reach such a consensus. But as Chapter 4 argues, there exist
principles that are universally accepted. Following these principles will go
a long way towards establishing a consensus in principle and a just society.
Proposition 2
An important role of policy studies is to illuminate the choice
parameters of society, how they relate to indicators that bear on the public
interest, and how different policy goals conflict and "trade off" among
themselves, so the public can participate in the discussion over the choice of
the policy parameters.
12
3. THE HIERARCHY OF POLICY GOALS

Traditionally, economists regard achieving economic efficiency and
promoting economic growth as important policy goals.
However,
sustainable development has become, in recent years, an even more basic
policy goal (Tisdell, 1995). Still more basic, and one that is almost
fundamental to the aspirations of all cultures, is preservation of the principle
of basic justice. 3 On top of these more long term objectives, there are other,
more specific, policy objectives, which emerge under specific contexts, and
which may conflict with these general objectives.
Thus, public opinion in Hong Kong during the several years leading to
the transfer of sovereignty in 1997 had put much pressure on the government
to curb the inflation of housing prices, to increase the housing supply, and to
increase home ownership. The Hong Kong Government decided to
intervene, with short-lived "success" in 1994 and then with remarkable and
certainly excessive "success" in 1997.4 Even though many of the
intervention initiatives were widely understood to compromise economic
efficiency, policy analysts cannot and should not simply dismiss the
objectives of increasing home ownership and raising housing supply as
incorrect or inappropriate. Similarly, the aspirations for instituting a
minimum wage or a level of income for each household have to be
recognized, even though an alternative mechanism may meet those
aspirations at a lower cost. Equalizing regional disparity is a common
concern in large countries such as Canada and China. Protecting young
people against sexual abuse, drugs, and crimes is yet another important goal.
Most of these policy goals are defined at a specific time and at a specific
place by the dynamics of social and political actions. Rather than
dismissing them off-hand we should ask:- at what cost is the policy
implemented? Do the benefits justify the cost?
We can see, therefore, that there is a hierarchy of policy goals. In
general, policies that come into being as a response to public demand can be
regarded as having specific, "second order" goals. Underlying these policy
goals, there are other, more long-standing, more fundamental social goals.
As alluded to earlier, economic efficiency, economic growth, particularly
sustainable development, are longer term and more general goals. More
fundamental still, the preservation of freedoms and social justice in the sense
of minimizing arbitrary welfare redistribution (Ho, 1997b) are extremely
important. They are important because there is evidence of widespread
support approximating a consensus in many cultures and through history.
In contrast to these longer term objectives, other objectives are much
more specific to the political context and can be described as second order
goals. In the face of the specific short-term goals it is convenient to treat
13
longer tenn objectives as constraints. Thus a policy aimed at providing

housing for the elderly must not excessively compromise economic
efficiency. Policies aimed at promoting economic growth must be
consistent with sustainable development and should not unduly disturb the
ecological balance in the living world. A policy aimed at curbing excessive
speculation in the property market must not contravene society's sense of
justice and must not punish investors to the detriment of entrepreneurship
and thriftiness.
The distinction between variables designated as constraints and
variables designated as objects for maximization is akin to that between
fixed costs and variable costs in the theory of the finn. In the theory of the
finn, fixed costs refer to costs which are fixed in the short tenn, i.e., which
are not subject to choice in the short tenn. Over the longer tenn, however,
they are also variable. Operationally, we cannot work out the optimal
values of all variables simultaneously and instantaneously, particularly when
the socioeconomic and the political environments are changing all the time.
Over the longer tenn, when the values of the society have undergone a
fundamental change, it will be necessary to revise the values of the variables
chosen as constraints. This is similar to revising the "fixed" factors of
production when relative factor prices have settled down to a pennanently
different set of values.
Proposition 3
More general, more basic, and longer term policy objectives should be
treated as constraints while more specific, less basic, and shorter term
policy objectives should be treated as objects for maximization. As the
system of values in society changes and as we gain more knowledge, policy
objectives designated as constraints may change.
4. COSTS, BENEFITS, AND OPTIMALITY

The concept of optimality, developed in economics and mathematical
programming, is useful in public policy studies. Contrary to what is often
believed, the cost-benefit calculus that is implicit in the concept of
optimality need not relate to economic efficiency at all. The cost-benefit
calculus is a method of policy analysis, and is not restricted to the economic
dimension. In a discussion of crime and punishment, for example, we can
talk about the cost and benefit to society of the size of a jury. Suppose
unanimity is required for a conviction. Increasing the size of a jury will
reduce the chance of wrongly convicting an innocent, which is a benefit. It
14
will, however, increase the chance of acquitting a culprit, which is a cost.

We cannot avoid considering costs and benefits in deliberating on such
matters. It is only when all the costs, direct and indirect, present and future,
economic and social, moral and non-moral, are considered that we can hope
that policies, over the long run, will do more good than harm.
Proposition 4
Intelligent decision making about policies should consider the full
range of costs and benefits, direct and indirect, present and future, economic
and social, moral and non-moral.
Over all optimality means the
maximization of net benefits. This requires an optimal choice of policy,
including the values of policy parameters, and implies the optimal trade-off
between conflicting policy objectives.
Take the example of the mandatory private provident fund (MPPF)

which began in Hong Kong in 2000. This is a plan similar to the Central
Provident Fund (CPF) in Singapore and Malaysia in being a forced savings
scheme but it is decentralised and operated by private fund managers. Each
policy parameter within the scheme has an optimal level: 5 the percentage of
employer and employee contribution out of the salary, the level of income
below which employees are exempt from the need to make contributions, the
normal age at which an employee can collect benefits, the age at which early
withdrawal is allowed and the conditions. Too large a percentage of
contribution would excessively burden enterprises and reduce disposable
income and hurt the quality of life prior to retirement. Too small a
percentage would lead to an accumulation of savings that will be too small
for retirement needs and would defeat the purpose of the exercise, and would
not worth the administrative cost that will be required to service the scheme.
In general, by making reference to certain stylized facts that apply to large
cross sections of the population it is not difficult to come up with a good
initial guess. Through an iterative process the initial values can be adjusted
to reflect the aspirations of the population.
The mandatory private provident fund scheme at its best-i.e., when all
its parameters are set optimally-must also be considered against other
alternative schemes. Introducing the MPPF may imply that other viable
schemes cannot be introduced, or may be introduced at a greatly reduced
scale. If the MPPF fails to deliver a benefit at least as large as the net
benefit of the best alternative scheme it should be scrapped. Any policy
designed for a specific purpose must be considered along with its competing
alternatives.
15
While some of the costs and benefits may be very difficult to estimate
accurately, "practical optimality"-a feasible state of affairs that is highly
desirable in its own right--does not require accurate estimation of costs and
benefits. Indeed, sometimes the expected benefit from a full-fledged
benefit-cost analysis may not be large enough to justify the benefit-cost
analysis itself. However, policy makers and the public should both be
alerted to all the dimensions and the nature of the consequences, so that
decisions over policy instruments and policy parameters are made with an
awareness of the full range of consequences. In this regard social scientists,
particularly economists, have an important role to play.
It is a pity that some areas of public policy have been
compartmentalized and policy makers in those areas have been given the
mandate to focus on a single dimension of performance. This underscores
the importance of the "systems perspective." For example, it is still often
held that central banks only need to achieve stable prices. One tragedy of
the eighties and the nineties is that a number of central bankers have singlemindedly pursued price stability to the complete neglect of economic growth,
employment, and social justice. The deep recession of 1980-81 in the U.S.,
which was associated with very high real interest rates aimed at "squeezing
inflation out of the system," was engineered by the U.S. central bank and
personified by Paul Volcker, the then Chairman of the Federal Reserve. It
succeeded in sharply bringing down inflation but left a legacy of large fiscal
deficits and high unemployment. 6 The same mistake was repeated by John
Crow at the Bank of Canada during the eighties. Although Alan Greenspan
has taken a much more flexible and pragmatic approach towards monetary
policy the lingering fear that a rise in real wages would bring uncontrolled
inflation resulted in a monetary policy that was effectively anti-labor. As a
result, notwithstanding years of good economic growth during the eighties,
workers in America had been intimidated by rising interest rates and the
threat of rising unemployment whenever there was some sign of an increase
in real wages. To wit, private sector hourly earnings in 1982 dollars
(according to the Bureau of Labor Statistics) showed that the 1989 figure
was $7.63, down from $8.17 in 1979. Only during Greenspan's reign,
when a broad range of macroeconomic indicators were looked at to
determine if there was overheating in the economy, did real wages rise
slightly, reaching $7.86 by 1999, still lower than what they were twenty
years ago.
16
Proposition 5
Policy studies should follow a systems approach so that students of
public policy are made aware of the different needs of society and the full
range of costs and benefits ofpolicies.
Social scientists will have done a great service if they succeed in laying
bare the constraints and trade-offs faced by society. This requires that they
illuminate the relationship between key policy parameters and key target
variables. This way policy decisions will not be made by default and will
be made as a conscious search for the optimal choice.
5. CONCLUSIONS
Policy makers work with policy parameters and deal with people. To
conclude this chapter we should remind ourselves of the need to distinguish
between basic policy objectives and less basic ones, and the general
applicability of the concept of optimality.
While there are many
dimensions of optimality and policies cannot please everybody, pursuing the
more universal, general principles will go a long way towards maximizing ex
ante welfare for society.
The Dimensions of Optimality

The example of health policy provides an excellent illustration of the
multiple dimensions of optimality. Do we have the optimal configuration
and quantities of medical infrastructure? Do we have the optimal balance
between resources devoted to prevention, and those devoted to diagnosis and
to treatment? Do we have the optimal structure of incentives, in the form
of fees, charges, and other forms of compensation for services rendered as
applied to the suppliers and consumers of medical services for them to
demand and supply the optimal amount and kinds of medical services? Do
we provide the optimal level and kinds of social medical insurance to
supplement private medical insurance?
In the case of education, do we have the right balance for resources
devoted to primary, secondary, tertiary education, and vocational training?
Do we give students the optimal amount of drills, tests, and assignments for
them to derive the greatest net benefit from such exercises? Do we
administer the optimal number of public examinations with the optimal
coverage or syllabus? Do we give would-be teachers the optimal amount
17
of training and in-service teachers the optimal amount of continuous training?

Do we have the optimal balance between autonomy for teachers and
directives from the Education Department?
Evidently, all of these dimensions of public policy cannot be attended
to by bureaucrats operating from the Central Government Offices. There
has to be an optimal degree of decentralization, and again there are different
dimensions of decentralization. Some decisions may be best centralized
while others may be best left to local decision makers. For example,
bureaucrats cannot possibly know enough about the students in a school to
know whether they will benefit from more tests, or from a particular style of
instruction. Officials in the Central Government Offices are not in the
position to judge how a local hospital should spend its equipment budget, or
whether the Police Department should spend more on its network of
informants or on rank and file police officers. On the other hand, the
central government should dictate the decision of "going metric" so as to
facilitate communication.
The Ex Ante Welfare Maximization Paradigm

Although the public consists of heterogeous people, and clearly no
policy will benefit different people equally, the design of most policies
should not be controversial if we assume that despite the differences people
are essentially the same-in the sense that if something is undesirable to A,
it would be undesirable to B too, provided that B was in the same boat as A.
As the next chapter argues, human beings share similar inclinations and fears.
If we make the assumption that what happens to somebody could happen to
anybody, and that it is the role of public policy to protect everybody from
big risks, then we are much more likely to come up with consensus policies
that aim at maximizing "ex ante welfare" for the representative individual.
If a policy is good for the representative individual, it is good for society.
NOTES
Mickey Kaus (1992) coined the term "the Law of Unintended Consequences," which is
just another name for the Lucas' Critique. He observed that each extension of welfare
created new problems, which in tum could seemingly be solved only by extending
welfare still further. "If the problem was that unemployed fathers were deserting their
families, then (liberals argued) you should offer welfare to poor families with
unemployed fathers who hadn't deserted. But that created an incentive for fathers to
18
2
3
4
5
6
become unemployed. To eliminate that incentive, you had to extend aid to families
who were unemployed, but nevertheless poor, which created another perveerse
incentive for the family to split up if the husband began earning enough to move out of
poverty." (p.112)
Rent seeking is an activity that is not productive for society and is pursued to capture
the benefits which otherwise may accrue to someone else.
See Chapter 4.
Housing prices declined more than 50 per cent producing negative asset values for a
large segment of otherwise economically vibrant households in the year after the
transfer of sovereignty.
Professor David Weimer offers the reminder that the first best optimum requires that
the policy parameters be optimized simultaneously rather than independently from one
another.
As the economy went into recession government revenue fell and the fiscal deficit
grew. Notwithstanding the argument made herein, even to date there are many
commentators who believe that central banks' role is to single-mindedly maintain
stable prices. Our argument is simple: fighting inflation should be the goal as long as
the benefit justifies the cost. So we have to remember there is a cost in every policy
act.
Chapter 3
HUMAN NATURE AND PUBLIC POLICY
Human nature is a vast subject. For the purpose of policy analysis

and policy design, however, what we need to know is the common concerns
and worries that human beings share. Human beings all pursue happiness
by engaging in various activities that are presumed to bring satisfaction and
joy. Such activities require the consumption of market goods and services,
but individuals' ability to transform such market goods and services into the
"substantive goods" that bring "utility" varies from person to person.
Moreover, the limited life experience of an individual constrains his
perception of his constraints and opportunities. As a result, individual
maximization behavior is based on preconceived notions of what matters
and what does not in generating happiness (perceived utility function) and
preconceived notions of what activities will generate what sensory stimuli
(perceived household production function).
"How selfish soever man may be supposed, there are
evidently some principles in his nature, which interest him in the
fortune of others, and render their happiness necessary to him,
though he derives nothing from it, except the pleasure of seeing
it... That we often derive sorrow from the sorrow of others, is a
matter offact too obvious to require any instances to prove it. "
Adam Smith: The Theory of Moral Sentiments, p.9
1. INTRODUCTION
Rationality is a traditional assumption in economics. Formally by this
is meant that a person has a stable objective function to maximize, implying
that his behavior is consistent and predictable. Economists see the
economic problem as maximization, at the individual or societal level, of
some objective function subject to constraints.
Yet rationality in household theory is taken to imply something more
than this. The objective function is called the utility function and has
20
normative connotations. Achieving a higher value of the objective function

is treated identically as achieving a higher level of welfare. Individuals are
depicted as entirely motivated by self-interest and thus selfish. Someone
who sacrifices his life for someone else will, according to this logic, be
regarded as selfish as he is considered to be merely pursuing his own utility.
This has invited criticism (Kohn, 1986) and is, as argued in this chapter, both
inaccurate and potentially misleading.
Altruistic behavior has attracted the attention of economists
(Hirschleifer, 1977; Oswald, 1983; Stark, 1989; Chami and Fischer, 1996)
and is typically modeled by including the utility function of others into one's
own utility function. I
This traditional approach has some important drawbacks. In its
unattenuated form, it assumes perfect knowledge-knowledge both of the
utility function (including the utility function of others in the case of
altruistic behavior) and of the constraints. The formulation does not allow
learning about the utility function-that of the individual, or that of others.
It is apparent that in the case of the altruistic model, how one's loved ones
fare in reality may not count as much as how one sees how one's loved ones
fare. Clearly, even if the son has attained a high level of utility it would
certainly not affect the father's overall utility unless it comes to his
knowledge. For the same reason, fathers often dictate a lifestyle for the
sons' benefit against their will in the belief that this is good for themwhether or not that turns out to be true. Rather than formulating the
objective function in terms of two lower-level utility functions, a logically
superior approach is to assume that an altruistic father has a perceived utility
function for a larger projected self that includes his son in a way Fromm
described in his Art of Loving (1957, p.24). However, we know from
experience that fathers do not, even with the best of intentions, always
maximize the true happiness of that larger self because there is often a gap
between perception and reality.
In this Chapter it is argued that perceptions are fundamental to
behavior. We shall introduce a general model that will accommodate
revisions of perceptions which can be described as learning and personal
development. Decisions are based on an ex ante perceived utility function
(as distinct from a true utility or "happiness") function. The perceived utility
function is actually only a strategy or decision function for the purposes of
making decisions. The individual, moreover, faces perceived constraints
rather than known objective constraints.
Similar in spirit to the approach taken here, De Palma et.al. (1994)
distinguished between the perceived utility function and the true utility
function. However, De Palma et. al. assumed that both the perceived utility
function and the true utility function are based on market goods, ignoring
21
problems arising from household production. They proposed an iterative

process in which an individual searches for the most effective or efficient
consumption bundle in terms of generating the attributes that contribute to
happiness (p.423). In contrast, we argue that because of limited life
experience and because life is short, individuals may never get to know
about certain attributes. As the realization of attributes requires time and
effort, the search for greater happiness is not a simple matter of spending on
alternative consumption bundles. A comparison of incremental utilities
based on marginal spending may not be possible or relevant. So a
convergent iterative process may not exist.
2. A MODEL OF HUMAN NATURE

People in real life display different preferences. This may be
explained in either of two ways. First is that they have fundamentally
different utility functions.
Second is that even though they have
fundamentally the same utility functions, they show different preferences
because of their different capabilities2 of realizing the "substantive goods" or
fulfillment attributes that affect utility.
There are at least two problems with the first approach. It could
imply that communication among human beings about feelings and emotions
is impossible. It also takes differences in "tastes" as given. The second
approach, on the other hand, has both the advantage that it allows such
communication, and the advantage that it offers an intuitively appealing
explanation behind differences in tastes. Even more important, it implies
that interpersonal comparison of utility is meaningful even if difficult.
To appreciate the intuitive appeal of the second approach, consider the
case of a blind person who will not appreciate what is visually beautiful
because he cannot. It is certainly inaccurate to say that he lacks a taste for
it. His problem is only that he cannot realize this attribute in his life.
Thus, realizing an attribute requires a personal "household production"
process that requires various inputs.
Proposition 1.' The Personal Nature of Fulfillment Attributes
Fulfillment attributes must be personally produced and realized.
While all human beings have the same true utility (happiness) function
in fulfillment attributes, people have different household production
functions,3 both because of their different endowments and because of
different specialization and increasing returns to specialization efforts.4
22
Moreover, even though they share the same true happiness function they
typically have different and changing perceptions about it. 5 Bertrand
Russell described this learning process thus:
In adolescence, I hated life and was continually on the verge
of suicide, from which, however, I was restrained by the desire to
know more mathematics. Now, on the contrary, I enjoy life ...
This is due partly to having discovered what were the things that I
most desired, and having gradually acquired many of these things.
Partly it is due to having successfully dismissed certain objects of
desire .... as essentially unattainable. But very largely it is due to
a diminishing preoccupation with myself.... (Russell, 1968, p.6)
Proposition 2: Diversity of Perceptions

Different individuals are in different stages of learning about the true
utility function and have different perceptions of what is desirable and what
is not.
Axiom: The Universal Nature of Human Nature 6
Human nature is universal.
What contributes to happiness is
essentially the same for all human beings. Formally, there is an objective
"true utility (happiness) function" that relates the state of fulfillment to
various ''fulfillment attributes,,7 and it is common to all human beings. 8
Traditionally, utilitarians have adopted the dictum that maximizing
happiness is the same as maximizing the balance of pleasures over pains,
while maximizing the greatest happiness of the greatest number is the same
as maximizing the total of individual happinesses thus calculated. They
assume, therefore, that utilities are both internally and socially additive. 9
I distinguish between happiness (true utility) and utilitarian utility as
follows. Happiness is the state of total well-being whereas utilitarian utility
is the summation of the balance of pleasures over pains. However, in
reality, pain and pleasure are both part of the life experience and may both
contribute to a fuller life and greater happiness. A person who has never
had any experience of pain in any form will not be able to communicate with
other fellow men and may not be able to experience or appreciate such
human experiences and qualities as love, courage, and will power. Such a
person would be the loneliest person on earth.
23
Definition: Happiness vs. Utilitarian Utility

Happiness is the state of total well-being whereas utilitarian utility is
the summation of the balance ofpleasures over pains.
We assume that the overall state of well-being for any representative

individual depends on four kinds of attributes that he realizes over his life:
health attributes, sensory attributes, mental attributes, and spiritual or
transcendental attributes.
Because of the limited life experience of each person, it is generally not
possible to know about all the attributes that affect happiness sufficiently to
produce an accurate ranking among them. Still, individuals are confronted
with choices all the time, and they are forced to make decisions.
They are
forced to make decisions by virtue of the movement of two kinds of cycles.
First is what I call an attribute/satiation fluctuation cycle. Second is what I
call a perceived opportunity cycle.
The attribute/satiation fluctuation cycle may be biochemically driven.
Thus hunger, thirst, or sex drive seeks to be satisfied and may resurface after
some time (satiation fluctuation).l0 Different dimensions of the health
condition may deteriorate and recover (attribute fluctuation). Fluctuations
in some perceived attributes, particularly mental attributes, may have some
unknown origin. For example, a sense of loneliness may strike from time
to time. The state of one's well being therefore typically rises and falls.
An individual will be triggered into action by virtue of the ups and downs of
perceived attributes. These cycles are exogenous to the person in the short
run but tend to become endogenous over the longer run. For example, the
taking of addictive drugs will bring about an attribute fluctuation cycle
which otherwise may not have existed before.
The perceived opportunity cycle refers to the coming and going of
perceived opportunities for the production of attributes. These opportunity
cycles may be internally driven, as one's capabilities of realizing attributes
will fluctuate, or externally driven, as the external opportunities come and go.
The opportunities presented to the individual in the short run are given, but
opportunities open to him in the long run may be affected by his decisions.
Proposition 3: Context of Decision Making
Movements of the attribute/satiation fluctuation cycle and the
perceived opportunity cycle drive individuals to make choices.
Because of the inherent impossibility of making decisions ahead of

time for one's entire life individuals do not maximize a known life-time
24
utilitylhappiness function subject to a known life-time opportunity set.

Instead, an individual at anyone time maximizes an ex ante perceived utility
function or, more appropriately, the life strategy function, over a self-defined
time horizon. Compared to true marginal utilities derived from the true
utility function U, the marginal perceived utilities of some of the relevant
attributes (which may be positive or negative) are exaggerated, while others
are assumed to be zero.
Definition: Life Skills

The ability to undergo various household activities to produce
fulfillment attributes and the ability to approximate the true utility function
are summarized by the term "life skills. "
Among the constraints that an individual faces, a key constraint is the
perceived household production functions, i.e., the set of activity
opportunities for transforming inputs of market goods and services, his effort,
and time into perceived fulfillment attributes. In addition, the individual
may also derive satisfaction or disutility from work and from training.
For someone with an opportunity to earn more by working for longer
hours (suppose, for example, he is paid by the hour at a uniform wage rate),
the perceived marginal utility of work is negative in equilibrium, since the
perceived marginal benefit of work in terms of higher income must exactly
equal the perceived marginal disutility of work. The efforts on improving
work skills and life skills, over the long run, can push out the constraints that
condition the maximization process.
Other. constraints include a budget constraint that says that the
individual's total expenditures plus his savings cannot exceed his income, an
employment opportunities constraint given his skills, and a time constraint
that says that the time allocated to various activities cannot exceed the time
that is available. In addition, the individual is subject to his own limitations
that can be described as a mental capital constraint. "Mental capital"
describes the degree of mastery of life skills at the time an individual faces
the choices of life. The accumulation of mental capital can be depicted as a
process of learning, the effectiveness of which depends on an ability to free
oneself from and reflect upon the constraint of the perceived utility function
and that of the perceived production function.
Proposition 4: Maximization ofPerceived Utility

Within the self-defined time horizon, the individual tries to maximize
perceived utility subject to perceived constraints (some of which may
25
coincide with true constraints}. This he does by pursuing various activities.

In pursuance of these activities he will need to consume market goods and
services. The "household production functions" transform market goods
and services, time, and other inputs into various "substantive goods,"
otherwise known as "characteristics," or "fulfillment attributes" that
contribute to true utility.
Just as there is a true utility function along the perceived utility

function, so there is a true household production function along the
perceived household production function. It is, however, the perceived
utility function and the perceived household production function that
detennine the individual's behavior. The individual is frustrated when an
activity is undertaken but it fails to generate the intended fulfillment
attributes.
As the individual makes his decisions, he will in time see the results of
those decisions.
Perceived attribute outcomes are compared with actual
outcomes, and perceived utility is compared with realized utility. The
individual attempts to find the causes of the success or failure of his actions.
This crucial process of interpretation will modify his behavior and his
perceptions through an adjustment in the perceived utility function and the
perceived constraints, leading to a change in his personal outlook and his life
strategy.
Proposition 5: Revision of Perceptions and Decisions
The individual compares realized outcomes with ex ante perceived
outcomes, realized utility with ex ante perceived utility, then modifies his
perceptions and behavior.
Definition: Personal Development
Personal development is a process of interpreting life experiences and
learning about the true utility function and true constraints.
Just as one can increase one's work skills by investing in human capital
and thus increase the ability to earn a higher income, so one can increase
one's life skills by a process of reflection. As one makes a greater effort in
improving life skills, the perceived utility function will change-to
approximate the actual utility function better.
The time horizon will
change so that he may become more forward-looking. Learning, however,
requires effort to break away from old habits. Moreover, some unhappy
experience may make him more risk-averse and reduce his time horizon,
26
while some pleasurable experience may make him overlook the

opportunities for satisfaction offered by other dimensions of the life
experience.
Definition: Life Entrepreneurship
Life entrepreneurship is an ability to reflect upon one's life experience
and to capitalize on the opportunities jointly presented to one by one's true
utility function and the household production possibility set.
Proposition 6: Human Weaknesses
Given the limited life experience of each individual and the lack of
knowledge about the possibilities of life, each individual is liable to overlook
some dimensions of the life experience. The individual is also liable to be
inhibited by habits acquired over the years and the fear about change, both
of which may prevent learning.
The formulation of the true utility function with happiness being

dependent on attributes may suggest that each attribute has an independent
effect on happiness. Actually, the experience of both pleasurable and
painful attributes, when considered in the right light, may enrich the life of a
person, build up his strength, make him more sensitive to the joy and pain of
other human beings, and thus increase his satisfaction as a living human
being far beyond the "net happiness" calculated as the excess of pleasures
over pains according to the traditional utilitarian calculus. This kind of
happiness is "spiritual" in nature and is based on the "total life experience,"
in contrast to the traditional utilitarian utility calculus which assumes that
pain and discomfort are always bad, while pleasure and comfort are always
good. Another aspect of spiritual happiness is derived from a feeling of
mastering and being at ease with oneself. It is a feeling of inner harmony,
the opposite of which is so aptly described by Ainslie, a psychologist, when
he coined the term "picoeconomics":
behavioral economics does not necessarily deal with the
case in which one part of an individual seems to undermine the
efforts of another part.... Earlier I had proposed, with tongue in
cheek, that the discipline that studies this case could be called
'picoeconomics,' that is, micro-micro-economics.... Just as
classical economics describes negotiation for limited resources
among institutions, and microeconomics describes such
negotiation among individuals, so picoeconomics describes
27
interactions that resemble negotiation among parts that can be

defined within the individual for control of that individual's finite
behavioral capacity (Ainslie, 1992, p. viii).
Proposition 7: Spiritual Happiness
Spiritual happiness is derived from going through and reflecting upon
the ups and downs in life. Spiritual happiness is based on a sensitivity to the
joys and sorrows of other human beings and an inner harmony achieved
through the resolution of inner conflicts.
One may find some inconsistency in this framework which

incorporates both utilitarian utility and spiritual happiness in one true utility
function. If both pains and pleasures contribute to spiritual happiness what
is the net effect of, say, a pleasurable experience on true utility? In general,
spiritual growth is a gradual process. Before the full development of the
spiritual personality, the individual attempts to maximize a temporal
perceived utility function over a self-chosen time horizon. 11 The temporal
perceived utility function is traditional utilitarian in nature. As the spiritual
personality gradually develops, utilitarian utility will count less and less,
while spiritual or total happiness will count more and more. The spiritually
developed person will be not be affected by the ups and downs in life to the
extent that a spiritually less developed person will.
3. DISCUSSION AND IMPLICATIONS

The Nature of Fulfillment Attributes (Substantive Goods)
The fulfillment attributes that I discuss in this chapter are similar to the
"substantive goods" that Scanlon (1991) and Harsanyi (1997) referred to.
Harsanyi's view of substantive goods closely parallels the discussion in this
chapter in that he noted that a person's own experience and disposition is
very much behind a substantive good's being desirable. This chapter goes
further and argues that a fulfillment attribute has to be personally produced
and realized to be meaningful.
Among the health attributes are the full range of physical faculties of
the body, including sensory, mobility, and thinking faculties. As well
freedom from pain and discomfort are included. Market goods and services
are often needed to produce and maintain the level of these attributes.
28
Among the sensory attributes are various stimuli received by the

body's faculties including sight, hearing, smell, taste, touch, and ideas and
mental pictures created through various media.
Among mental attributes are the sense of security versus fear, the sense
of recognition versus exclusion from one's identified social group, the sense
of superiority versus inferiority, the sense of relative fulfillment vs.
deprivation,12 the sense of self-esteem and self-realization versus the loss of
such self-esteem and self-realization, and the sense of autonomy and
freedom.
Different individuals are assumed to value these mental
attributes the same but they produce these mental attributes in different ways
and with varying degrees of efficiency.
Mental attributes are often produced and destroyed through various
household activities interacting with one another. Jealousy is a mental
"bad" due to a feeling of relative deprivation as others are observed to
possess something desirable. Fear is a mental "bad" that can be caused by
observing a large influx of immigrants who bring new values and behavior
to the society. The resulting racist behavior may cause more fear as a result
of backlash prompted by racist behavior. However, self-dignity and selffulfillment may substitute for relative fulfillment, while confidence can
overcome fear.
Reference to mental goods and bads allows us to explain things that
seem to run counter to rationality. For example, Ng (1984), using what he
described as compelling axioms, proved that maximizing expected utility as
von Neumann-Morgenstern suggested is rational, implying risk neutrality
with respect to the dispersion of utility outcomes. However, he only
considered the realized utilities of alternative risky outcomes as being
relevant in decision making in his set of axioms. He did not consider the ex
ante disutility of the mental bad in the form of fear and uncertainty arising
from having to face risky outcomes. Once this mental bad is accorded
negative utility, it is not at all clear that maximizing the mathematical
expected value of realized utilities is rational, while choosing a less
uncertain prospect involving a somewhat lower expected utility is irrational.
Proposition 8: Mental Goods and Bads

Mental goods and mental bads, often experienced ahead of the
realization of the outcomes, which are thought to have direct impact on
utility, affect the true utility of individuals.
29
The Perceived Utility Function, the Perceived Household

Production Function, and the Perceived Constraints
In contrast to the true utility function that determines how happy one
really is, the ex ante perceived utility function is only a "strategy function."
To see the nature of this strategy function consider someone going to a new
restaurant and having to choose from an unknown menu.
Although a
"preference" may be registered it is not a true preference. The fact is with a
limited life one cannot have a full range of experience to enable one to tell
what is best for oneself. Living is a process of redefining the perceived
utility function and discovering what is good and what is bad. At any given
time, maximization is based on one's limited perception and prejudices.
Information is generated and reinterpreted. Ex ante perceived utility
functions and perceived constraints are redefined. Behavior is modified.
The ex ante perceived utility function is the "utility function" actually
estimated in empirical studies. It is the basis on which households make
their decisions regarding what to buy in the market place and what
household activities to engage in. To the extent that information is
imperfect and households have to operate in an uncertain environment they
often look at one another in revising their strategy functions. Pingle (1995)
showed that people often modify their behavior and decisions by a process
of imitation. Sah (1991) introduced the idea of "social osmosis" and
suggested that individuals form subjective probabilities about apprehension,
conviction, and punishment for criminal activities (which is one form of
"household production") under influence from their social groups.
Just as the ex ante perceived utility function will change from time to
time, the perceived household production function will also change. Thus
when an individual is in a rat race trying to keep up with the Joneses there is
no presumption that he becomes better off with greater and greater
consumption of market goods. This is because the mental goods are being
destroyed even as more and more material goods are consumed.
Differences in the household production functions among different
individuals are fundamental to the difficulty of interpersonal comparison of
utilities.
Some people may have very efficient household production
functions and can realize self-recognition (a mental good) with very little
resource input. Other people may have inefficient household production
functions. Because the attributes that count in the true utility functions
must be personally produced and realized, inferences of welfare based on
differences in physical resource consumption are generally not meaningful.
30
Proposition 9: Interpersonal Comparison of Utility

Because of differences in household production functions,
interpersonal comparison of utility based on differences in physical
consumption is not meaningful. Interpersonal comparison of utility based on
fulfillment attributes, on the other hand, is both possible and meaningful.
Many of the constraints that households face are actually perceived

constraints rather than actual constraints. Life is not only a process of
discovering one's true utility function, but it is also a process of discovering
one's potential by ever pushing back perceived constraints.
The tragedy of life is that very often individuals ignore true constraints
while creating imaginary constraints. I3 The life experience involves
learning about the true constraints. As it turns out, some people engage in a
process of virtuous circle of positive learning and development, while others
fall into a vicious circle of negative learning and "immiserising
development. "
Some people fail to invest in work skills and life skills not because of
inherent irrationality, but because their limited outlook of life make them
project a large cost in terms of the marginal effort needed to achieve skills
and a relatively small return in terms of the benefits that will accrue from
them in the future.
Our model has important implications for benefit-cost analysis. In
general, most benefit-cost analyses as practiced today are based on
If the
compensated variations calculated with estimated utility functions.
estimated utility functions are only perceived utility functions and they are
subject to misperceptions, then the compensated variations derived can be
quite misleading in terms of welfare implications of policies.
In particular, it is common among economists to estimate the value of
human lives by surveying respondents' willingness to pay in order to obtain
marginal reductions in life risks.
These exercises may be quite misleading
if the respondents have wrong perceptions to begin with. For example, if
we ask a teenager suffering from a depression how much he values his life,
the value reported may be negative and he may indeed behave as if life had
negative value. But this may be because he is obsessed with his temporary
set-back, and he may have completely overlooked the range of life
experience that he may yet explore.
31
Proposition 10: Benefit-Cost Analysis

Benefit-cost analysis based on empirically estimated utility functions
and the contingent valuation method may be misleading if households'
perceptions deviate significantly from reality or are limited by experience.
Discount Rates and Risks

According to our model, there are two reasons behind the appearance
of a rate of time preference. First, the individual constantly redefines his
time horizon as his perception of his constraints changes. A poorer person
living in a highly dangerous place with a short expected lifespan will,
according to the model, have a high rate of discount because he does not
look forward to living very long. An elderly person is also expected to
have a high rate of discount. These different discount rates are not truly
rates of time preference. Only because they perceive their constraints
differently, they form different strategy functions.
The second reason behind the appearance of a rate of time preference
relates to the satiation/attribute fluctuation cycle and possible changes in the
household production function. Depending on the ups and downs of the
satiation/attribute cycle, something that is useful now may not be useful in
the future. Depending on changes in the household production function, an
attribute that can be realized today may not be realized in the future. One's
biochemistry may not give one the desire or the ability to produce a specific
attribute.
Proposition 11: Rate ofDiscount
It is rational to have a pro-present rate of time preference for specific
consumption which is subject to the satiation/attribute cycle and the
perceived opportunity fluctuation cycle. The rate of discount should be
smaller for generalized purchasing power than for specific goods, and there
should be no discount for future utility.
A number of studies have borne out the implications of this theory.

Lawrence (1991) is one of them. Poorer people are found to have higher
rates of time preference, suggesting that time preference may not have
anything to do with preference per se but with differences in perceived
opportunities. The implication that older people have a higher rate of
discount apparently is contradicted by Chaloupka (1991) who, in his study of
cigarette smoking and addictive behavior, discovered that older people
32
apparently do not discount the future at all. This result was inferred from
the fact that the coefficient for consumption of cigarettes in the "future
period" is not much different from that for consumption of cigarettes in the
"current period." Actually, in the empirical study, reported current
consumption is taken as "future period consumption" while the reported
lagged consumption is taken as "current period consumption." The
empirical study also required statistics on "consumption in the previous
period." This was taken as zero for those who started smoking within the
past two years, had stopped smoking more than two years before the
interview, or had never smoked before. For others maximum consumption
was used as a proxy for lagged consumption. To conclude that the elderly
had a zero or low discount rate on the basis of such statistical results is
erroneous. But the results do indicate a positive time preference for
specific consumption, and suggest that observed "time preference" is related
to the risk of non-survival. While realized "future" consumption is not
discounted, the observed low demand elasticity with respect to price for the
elderly (pp.739-740) suggests a high discount rate. A low demand
elasticity implies that cutting back current consumption in response to a
price increase to increase future consumption is not valued highly by the
elderly.
Mental Bad and Ex Ante Perceived Utility

In an uncertain environment, traditional economics takes rationality to
imply the maximization of the (mathematical) expected value of the
objective function. If two alternative states of the world are possible, each
with a known probability, the individual is assumed to maximize the
probability-weighted average of the values of the utility function under the
two alternative states of the world. This is the Bemoulli-Morgenstern-von
Neumann theory, but this has been questioned as being inconsistent with
some observations. 14
Our distinction between ex ante perceived utility and realized utility,
and our reference to the perceived ex ante disutility of an uncertain prospect
mean that people may be risk-averse independently of the effect of the shape
of the utility function defined over outcomes. According to the von
Neumann framework, consumers are assumed to maximize the expected
value of realized utility outcomes. Within our framework, persons may
maximize a perceived, ex ante, utility function whose value may well vary
with the variance of the utility even when the expected utility is the same.
In particular, given the fact that a person has a limited time horizon and
repeated trials for an extended period is often infeasible or irrelevant, he may
33
well be averse to a prospect involving a small risk of a large welfare loss but
a large chance of a relatively small welfare gain, even if the prospect implies
an expected ex post utility gain. One cannot deny the fact that ex ante and
at the time of decision making, 50 utils guaranteed is different from the
prospect of an equal chance for 0 and 100 utils.
Once again in terms of
our framework, perceived insecurity due to the variance of the realized
utility is a mental bad independently of the utility derived from outcomes
and may tip the balance of attraction in favor of the guaranteed 50 utils.
Proposition 12: Expected Utility Framework vs Ex Ante Utility
The von Neumann-Morgenstern Expected Utility framework ignored
the ex ante mental bad arising from the distribution of ex post utilities.
Once this is taken into account, it is not always rational to maximize the
mathematical expectation of ex post utilities. At the time of decision
making, given uncertainty, people maximize perceived ex ante utility.
Racism, Parochial Nationalism, and the Productivity of

Education
Racist and nationalistic behavior stems from household production that
creates "mental outputs" that are positive for some but negative for others.
They stem from the perceived good feeling of being more secure from threat
by aliens and being superior over others. Clearly, the perception of threat is
enforced every time a member of one's own race is attacked or unfairly
treated. An economic downturn that throws people out of jobs may also
increase perceived threat and thus create a "mental bad." On the other hand
an economic recovery may reduce such perceived threat and thus create a
"mental good." Any racist behavior, unfortunately, is inherently counterproductive because it engenders ill will and destroys valued mental goods.
On the other hand, a sense of security is promoted by a sense of equality,
respect for one another, and protection under the law.
Welfare maximization is not achieved just by maximizing physical
output. Larger physical output relaxes only one of the many constraints for
welfare maximization. Equally, if not more, important is the pushing out of
mental constraints. Resources can and should be devoted to pushing out
our mental constraints. Individuals should be educated in life skills. With
better mastery of the reality, an individual is better positioned to take
advantage of the opportunities of life. However, to master these life skills
requires a strong desire and an open mind to learn to interpret life
34
experiences positively-i.e., in a direction that will enhance realized utility.

The community should work to produce mental goods such as a sense of
security, equality, and self-respect and should learn to steer away from
mental good destruction activities such as intolerance and racist jibe.
Education that causes a change in attitude by exposing an individual to more
dimensions of life directly modifies the efficiency in the production of
certain mental attributes and thus may have productivity far beyond the
imagination of those concerned only with the development of job skills or
with education as a consumption good.
Proposition 13: Life-Skill Enhancing Education
Life-skill enhancing education is highly productive.
to realize more fulfillment attributes with less resources.
It allows people
4. CONCLUSIONS
One basic premise of this book is that public policy must work with
human nature and must not work against human nature. This chapter
argues that despite the appearance of diversity, there is a universal human
nature. The apparent diversity arises largely because of differences in the
abilities of households to produce the substantive goods which they all value
and because of differences in the stage of personal development and the
ability to learn. Behind the veil of diversity, it is part of human nature to
abhor big risks, to value autonomy and freedom, to enjoy being accepted as
part of a social group and recognized and respected as an individual, and to
respond to material and psychological incentives.
The subject of human nature has been an ongoing theme of great
Veblen (1934), however, objected to the
interest to economists. 15
rationality assumption made almost universally by economists. In his view,
human action is instinctive rather than rational, and is based on impulsive
desires rather than maximizing calculations. To be sure, people often do
act impulsively. Yet, behind most instincts there is rationality. The
instinctive withdrawal of a hand from a flame is part of nature's plan to
preserve his life. Sexual drives and instincts are part of nature's plan to
preserve the species. An instinctive "time preference" reflects the working
of the attribute/satiation cycle and life risks. Quite apart from these
considerations, it is argued in this chapter that individuals' perceptions are
limited by their experiences and by their mental constraints, and this
conditions maximization.
35
In recent years, the role of changes in perception in household choice

has attracted increasing attention among economists.
Pingle (1995)
suggested that individuals may make choices on the basis of imitation when
"comparing alternatives is relatively costly." (p.281) Dietz and Stem (1995)
introduced the concept of "socially embedded preference." They again
assumed that this was a departure from the rational choice paradigm. But
to say that a decision strategy is not rational because it is based on cost
considerations seems to be a contradiction in terms. This chapter suggests
that household behavior is based on maximizing a perceived utility function
subject to perceived constraints. The perceived utility function is by nature
a strategy function that is only an instrument for maximizing true utility. It
changes with experience and with information collected from the social and
physical environment. Likewise, perceived constraints as well as actual
constraints change over time. Personal development is a process of
learning about one's true utility function and learning about and realizing
one's true capabilities. Public policy development is a process of learning
about human nature and finding policy designs that best fit in with the
aspirations of human nature. This process can be called ex ante welfare
maximization.
NOTES
2
3
4
Thus an individual may have a utility function written as follows:

U(cl, u2(c2))
where cI is his own consumption and u2(c2) is the utility of his family. It is also
common to model U as comprising two lower level utility functions (e.g., Stark, 1989).
Thus:
U = wlul (cl) + w2u2(c2)
where WI and w2 are weights of the lower-level utility functions ul for himself and u2
for his family.
c.f. Sen (1985).
This approach is strikingly similar to Stigler and Becker (1977), which was succinctly
interpreted by Muellbauer (1987). The similarity was pointed to me by Prof.
K.Y.Tsui of the Chinese University of Hong Kong.
Yang and Ng (1993) discussed specialisation in the production of goods. Here we
note that household production in the production of direct objects of consumption or
attributes is also subject to specialisation. One thus needs to learn to enjoy (realize
the attributes associated with) classical music. Learning to enjoy classical music may
prevent one from learning to enjoy watching sports games.
This line of reasoning remarkably parallels that of Harsanyi (1997), who distinguished
between "informed preferences" and "actual preferences." (p.140-141)
36
7
8
9
10
11
12
13
14
15
An axiom is a statement assumed to be true but one that cannot be verified empirically
or logically. However, the universal nature of human nature is consistent with the
similar way people of different cultures respond to incentives and objects of fear so
there is such a thing as behavioral science.
This approach is borrowed from Lancaster (1966) but Lancaster has in mind objective
attributes, unlike what is referred to here, which are the attributes that a person himself
realizes through household production.
c.f. Stigler and Becker (1977) and Harsanyi (1997), p.141.
Internally additive utilities need not imply zero cross derivatives, as the Total Marginal
Utility of X may comprise the partial derivative of U with respect to X plus the cross
derivative ofU for Y with respect to X.
This can be described as a readiness or a capacity to realize certain attributes.
Readers may be interested to find that this framework is consistent with Maslow's selfactualization framework (Maslow, 1965).
The rat race has attracted the attention of economists including Galbraith (1969 ) and
Ng (1997)
c.f. Russell (1968), p. 6, previously cited.
See Fishburn (1988).
See Freeman (1993) for a historical review.
Chapter 4
INSTITUTIONAL FOUNDATIONS FOR A JUST
SOCIETY
This chapter distinguishes between fundamental justice and

incremental justice and argues that the HarsanyianlRawlsian, ex ante,
concept of justice is the only concept of justice relevant to the design and
evaluation of institutions. Unlike incremental justice for which a concensus
as to what constitutes justice is generally not possible the conditions that
satisfy the HarsanyianlRawlsian concept of justice are derived from the
assumptions of rationality and aversion to large risks, and the postulate of
fairness. A concensus occurs not fortuitously but inevitably. The chapter
develops eight principles of institutional design that contribute towards a
just society and that follow logically from these assumptions and postulates.
The chapter argues that these principles are by and large needed for social
welfare maximization, so that justice is generally consistent with efficiency.
The chapter applies the theory to the concept of exploitation, crime and
punishment, as well as labor market and social security, to illustrate the
working of the principles developed.
".. justice, a thing more precious than much gold. .. "
"Injustice is never more profitable than justice. "
Plato, The Republic
1. INTRODUCTION : TOWARDS A DEFINITION OF A

JUST SOCIETY
In the view of Socrates, as related by Plato, justice is profitable and
enhances the quality of life. Notwithstanding the common belief that Plato
held the view that justice and moral conduct should be valued for their own
sake, throughout much of the discourse in The Republic Socrates promotes
the cause of justice on the ground that justice is ultimately conducive to
38
happiness. In asserting that speaking the truth and paying back a debt one
may have contracted would not be just if such actions were badly timed and
reduced happiness, he comes close to defining justice as a mode of conduct
that brings greater happiness or the social good. I "Everyone would surely
agree that if a friend has deposited weapons with you when he was sane, and
he asks for them when he is out of his mind, you should not return them."
(Plato, pp. 5-6)
In important ways John Rawls' Theory of Justice (1971) corresponds to
Plato's views. According to Rawls, the concept of a just society is based on
some notion of "fairness" that should be universal. What constitutes a just
action should therefore be capable of being reasoned and therefore not
controversial. He maintains that principles of justice should be those that
"free and rational persons concerned to further their own interests would
accept in an initial position of equality as defining the fundamental terms of
their association." (p. 11) In saying this Rawls follows the Platonic
assumption that justice is consistent with one's expected self-interest.
Perhaps the most celebrated element of Rawls' theory is the proposition that
principles of justice should be chosen "behind a veil of ignorance" about
what initial position each individual would find himself, so that "no one is
able to design principles to favor his particular condition." (p.l2) While
Rawls is usually associated with this hypothetical procedure, the
hypothetical procedure can be traced much earlier to Harsanyi (1953, 1955).2
The principle of impartiality in social welfare judgments and analysis was
also emphasized by Mill, whose utilitarian notion of justice requires agents
to be strictly impartial between their own happiness and the happiness of
others when they make judgments (Mill, 1969, Vol. X, Chapter IV).
It should be noted that the notion of fairness and the requirement of
acceptability to free and rational persons without predetermined interest
would imply non-arbitrariness. That is, the rules about distribution of
welfare must be agreed upon ex ante rather than on an ad hoc basis after a
distributive process. This would imply equal distribution of the initial
resource endowment and subsequent distribution of incomes according to
merit or other allocation mechanism elected through social consent.
The HarsanyianlRawlsian approach defines what I call fundamental
justice, which looks at basic rules of justice while ignoring the question of
whether a specific change from the status quo is more just or less just. The
actual distribution of incomes and wealth at any given time is the result of
the working of many factors, including the working of the principle of merit,
historical and cultural forces, as well as random factors. Redistributing
actual incomes and wealth is incremental and not the essence of Rawlsian
justice. On the other hand while the assumption of everyone being behind
a veil of ignorance is hypothetical it gives us a framework to evaluate
Institutional Foundationsfor a Just Society
39
alternative institutions. Thus we can conclude, for example, that a random

redistribution of incomes or wealth that is imposed on members of the
society involuntarily would be arbitrary and hence unjust. On the contrary,
voluntarily assumed risks from lottery-like arrangements are consistent with
justice because they are not arbitrarily imposed (Friedman and Savage, 1947;
Ng,1965).
To illustrate the concept of incremental justice consider the case of a
very poor man stealing from a very rich man, the case of Robin Hood
stealing goods from the rich and giving them to the poor, the case of a
government taxing the rich heavily and transferring to the poor, and
affirmative action programs in favor of minorities. In such cases a
concensus view about justice is impossible, because a person's ethical
position about the matter is likely to be colored by his background and
interest. In a communication with the author, Gordon Tullock finds the
notion of "veil of ignorance" problematic. As he says, "behind the veil of
ignorance, you know what nation you belong to. ... [I]f we divided our
income evenly with the Indians and the Chinese [Rawls] would never have
been able to get his book published." Tullock's point is well taken and
relevant with respect to incremental justice but not with respect to
fundamental justice. As we shall see, we would have come a long way in
illuminating what constitutes just and unjust institutions, if only we used the
uncontroversial concept of fundamental justice alone. It should be added
that, notwithstanding what has been said earlier about the desirability of
equal wealth distribution in the initial position, the Rawlsian principle does
not imply that it is just to equalise actual incomes and wealth. Before we
proceed further, let us recall our assumptions about human nature as
discussed in the last chapter:
We will state the following definitions:
Human beings are assumed to be rational utility maxzmzzers and
characterized by an aversion to pain and an affinity to pleasure. They are
also assumed to be averse to risks which are sufficiently large. 3 Human
beings are also assumed to value freedom and autonomy.
Definition ofArbitrariness
Any redistribution of welfare, incomes, or wealth or any decision rule
that has an impact upon someone's welfare, incomes, or wealth that does not
follow principles agreed upon by free and rational individuals acting behind
a veil of ignorance is arbitrary.
40
Definition ofJust Society

A just society is defined as one such that its institutional arrangements,
particularly those governing the distribution of the initial endowments and
the accrual of incomes and welfare, are acceptable to free and rational
persons who have no predetermined interests.
Definition of the Degree ofJustness
It is postulated that free and rational persons with no predetermined
interest have common and consistent ordering among alternative
institutional arrangements which differ only in their implications on risk and
the degree of arbitrariness. A set of institutional arrangements A that is
characterized by less arbitrariness than B is by definition "more just" and
will be preferred, other things being equal.
2. A UTILITARIAN APPROACH TO INSTITUTIONAL

CHOICE
The foregoing suggests to us that other things being equal, we should
opt for institutions which are more just. That is, we should try to minimize
arbitrariness or maximize "justness," unless the greater justness is gained at
the expense of other socially desired objectives. In practice, reducing
arbitrariness carries a cost, so that there exists "an optimal degree of
justness." We can formulate the following maximization problem:
Lemma: Social Welfare Maximization

Social welfare is ex ante maximized (with respect to institutional choice)
when the most preferred institutional arrangements among all alternatives
available is implemented. 4
This approach to social welfare maXImIzation is clearly utilitarian.
Institutions are chosen not because of their inherent qualities but because of
their implications for social welfare. However, while the father of
utilitarianism, Jeremy Bentham, implored us to maximize "the greatest
happiness of the greatest number," many people are not prepared to accept
adding 100 "utils" for one person is equivalent to adding one "util' for 100
people. In contrast, the ex ante social welfare maximization approach
absolves us from this difficulty. Assuming we are all behind a veil of
41
ignorance, we are all identical for the purposes of contributing to a collective

decision: we have the same chance to take up any particular utility function,
and the same chance to enjoy the abundance or the lack of the "capability to
convert primary goods to substantive freedom" (Sen, 1992). We would not
know if we are black or white, clever or handicapped, fat or thin, beautiful or
unsightly. Because we are all identical ex ante there is no need to sum up
the realized welfares of different people and no need for distributional
weights.
Summing up realized welfares and comparing the "total
happiness" under one state with that under another state would be
tantamount to evaluating incremental changes, in contrast to the proposed ex
ante approach.
By definition, the ex ante preferred set of institutions is efficient
because it maximizes expected welfare. Note that to make an intelligent
choice about our institutions we only need to assume (i) that we are all
rational utility maximizers and that we share a common utility function
defined over "substantive goods," (ii) that we share an aversion to pain and
an affinity to pleasure, (iii) that we share an aversion to large risks, and
finally (iv) that we value freedom and autonomy.
3. HARSANYI/RAWLS VS ARROW
While Harsanyi and Rawls are implicitly interested in ex ante welfare
maximization and have defined justice in the ex ante, fundamental sense,
justice may also be defined in the ex post, incremental sense. 5 This
approach appears to be implicit in Arrow (1950).
Arrow's analysis started with the social welfare function, which is an
indicator of social welfare based on the welfare of the individuals
constituting the society. There are some basic properties which a social
welfare function should have. One basic property is consistency. Given
the individual orderings for alternative social states (one ordering for each
individual), there has to be a corresponding and consistent social ordering of
the alternative social states (Arrow, 1950). Arrow made the distinction
between tastes and values. The former reflects orderings of social states
based on the direct consumption and hence welfare of the individuals while
the latter reflects also the general standards of equity of various individuals.
A just society should reflect the preferences of all individuals rather than
those of one individual (nondictatorial). A just society should also allow
the freedom to choose among the alternative social states available even as
their values change.
Using such an ex post approach and making some general and
reasonable assumptions, Arrow derived the famous "Possibility Theorem": if
42
we exclude the possibility of interpersonal comparisons of utility, then the

only methods of passing from individual tastes to social preferences which
will be satisfactory and which will be defined for a wide range of sets of
individual orderings are either imposed or dictatorial (Arrow, 1950, p. 24).
Arrow's apparent misgiving about the inevitability of the imposed or
dictatorial rule suggests that in his mind justice should imply giving due
weight to each individual in a social choice decision. This "due weight"
may involve recognizing the (realized) utilities of individuals in the social
welfare function or recognizing the role of individuals in the design of social
choice decision rules. This misgiving about the result that he derived so
elegantly which has subsequently been referred to as Arrow's Possibility
Theorem is apparent from the following passage:
To the extent that individuals are really individual, each an
autonomous end in himself, to that extent they must be somewhat
mysterious and inaccessible to one another. There cannot be any
rule that is completely acceptable to all. There must be, or so it
now seems to me, the possibility of unadjudicable conflict, which
may show itself logically as paradoxes in the process of social
decision making (Arrow, 1973, p.263).
The inherent difficulties of social decision making can be illustrated
using the following example. Consider a society with two individuals A
and B. Under the ex post approach, we would be interested in the
configuration of realized welfare of the two persons. Suppose three
alternative social states are possible so that in the first state, U A = 100, and
UB = 20; in the second state, UA = 50, and UB = 50; while in the third state
U A = 20, and UB = 100. Arrow could not find a mechanism to determine the
social ordering among the three social states that is most acceptable. The
difficulties involved are obviously inherent in the lack of an objective set of
criteria to adjudicate between the conflicting interests of A and B.6
The ex ante approach offered by the RawlsianlHarsanyian framework
allows us to consider the problem of social choice from another perspective.
Under this approach we would not be interested in any of the three outcomes
at all. Instead, we ask A and B to forget about their identities and instead
look at alternative institutional arrangements under which they would live.
We would look for those arrangements that are most acceptable to both A
and B if they have no idea which welfare or social position they would
assume. According to Rawls, under this assumption a universal concept of
justice exists. We argue that this alternative approach has important
applications beyond the adjudication of day-to-day conflicts among
individuals, namely in the realm of institutional design.
43
The contention that most practical decisions are in fact made

incrementally in a historical context by real people with different
backgrounds is well taken. However, if we are looking for the set of
institutions that is consistent with the concept of justice it seems that the ex
ante approach, which assumes impartiality, rather than the incremental, ex
post, approach, which assumes existing interests as given, is both more
appropriate and less controversial. Judgments about "incremental justice, "
which relates to changes in the social state from the status quo, are bound to
be controversial and "unadjudicable."
4. OPTIMAL INSTITUTIONAL ARRANGEMENTS

We can instil further, more specific meanings behind HarsanyianRawlsian, ex ante fundamental justice. Let us consider a hypothetical world
in which a mechanism for randomly picking one member to serve as a slave
for the rest is instituted. To the extent that everyone has equal chance to be
picked as the slave the mechanism can be said to be "fair." Yet we would
not call this a just society because someone is victimized arbitrarily against
his consent.
For the same reasons, if a mechanism is instituted such that everyone
has the same chance to be picked to have all of his wealth redistributed
among the rest of the population, the society cannot be said to be a just
society. Take a still less extreme example-the case of everyone being
subjected to the same chance of being picked to have one per cent of his
wealth redistributed among the rest of the population. We still would not
call it a just society, unless the mechanism was agreeable to everyone.
Note that in each of these examples, one person loses while other
people gain in the random process. In the traditional sense of the Pareto
principle, we cannot say that the random mechanism is Pareto-deteriorating.
However, in the ex ante sense, to the extent that everyone abhors the
mechanism, introducing the mechanism is obviously Pareto-deteriorating.
Eliminating such a mechanism when it exists is not only just but also Paretoimproving (efficient 7). It should be noted that in the above examples the
risks are not borne voluntarily.
Definition of Residual Risks
Risks that are thrust upon individuals and cannot be avoided are called
residual risks.
44
Proposition 1
The Principle of Residual Risk Reduction is a necessary condition to a
just society. In order to maximize expected social welfare a society must
reduce "residual" or unwanted risk that causes arbitrary welfare
redistribution among its members as long as the marginal benefit of the
residual risk reduction achieved is higher than the cost of reducing such
risks.
The concept of justice, then, stands in opposition to arbitrariness.

Apart from being imposed institutionally, "arbitrariness" may also come
about as a result of the randomness of natural processes ("acts of God").
Such randomness may occur to a person before birth through genetic
differences or after birth through all kinds of "accidents," both favorable and
unfavorable. s If we are all put behind a "veil of ignorance," and if we all
want to maximize our expected welfare, we would seek a mechanism
whereby the risks imposed by the natural random process can be minimized.
The Principle of Insurance provides exactly such a mechanism. Through
such a mechanism the effects of unhappy events are diffused so that the
sufferings of individuals who are hit by misfortunes are reduced. In the
real world insurance is often available in the market place. When, however,
private insurance will not cover certain individuals, mandatory or stateprovided insurance may be necessary.
Proposition 2
When the arbitrariness inherent in residual risks cannot be avoided
through social action or reducing residual risks is too costly, insurance
mechanisms that reduce the impact of arbitrary welfare assignment that
occurs as acts of God (such as an earthquake) or acts of men (such as armed
robbery) through a mechanism of insurance make the society more just.
Mandatory social insurance makes the society more just and possibly though
not necessarily more efficient. Voluntary private insurance, other things
being equal (in particular in the absence of social insurance), makes the
society both more just and more efficient.
Apart from residual risks, unequal opportunities are also arbitrary and
are therefore unjust. Unequal opportunities prevent people from competing
on an equal basis. In the job market this results in less competent people
getting the jobs at the expense of more competent people. In the
engineering works market this results in weaker contenders getting the
contracts at the expense of stronger contenders. This is clearly inefficient.
45
The Principle of Equal Opportunities, which is obviously fundamental to

justice, once again is consistent with efficiency.
Proposition 3
A just society abides by the Principle of Equal Opportunities. This
implies absence of discrimination based on race, sex, religion, or other
irrelevant considerations. This also implies that newborns need to have
equal opportunity to develop their potential, i.e., "equality of life chances." 9
Proposition 4
Pure redistribution that blunts the principle of merit is unjust unless
the degree of redistribution is acceptable to all behind a veil of ignorance.
In order for institutional arrangements to be acceptable to free and
rational persons with no predetermined interests, so that a society can be
called just it must also have just laws, effective law enforcement, and just
punishments. Just laws are proscriptive in a way that is agreeable to all
members of society "behind the veil of ignorance" about where they would
belong in society. They specify what behaviors are unacceptable and need
to be punished. Just laws must also be made known to and easily
understood by people. If they are known to some people but not to others
offenders may be arbitrarily victimized because they happen not to be aware
of the laws. They must minimize any arbitrariness both in design and in
implementation.
In other words they should not be enforced randomly or
selectively.
Proposition 5
A just society must have laws that clearly and unambiguously define
what behaviors are lawful and what behaviors are unlawful, and that are
agreeable to all members of the society if they were behind a veil of
ignorance about where they would belong.
Just laws need to be complemented with just punishments. Following
the requirement of non-arbitrariness, just punishments must be
commensurate with the nature and severity of the offence; they must not
produce "spill-over" punishment on innocent people (explained below); and
they must be well defined and precise so that the relative and absolute level
of severity of each punishment is clear to the judge, which is necessary if the
judge is to determine what is the appropriate punishment in each case.
46
Proposition 6
A just society needs to have just punishment to complement the just
laws. 10
All of the above has to do with arbitrariness externally imposed from

the environment or internally given by virtue of inborn differences. There
is still another aspect of arbitrariness that arises from the interaction of
inborn characteristics and the environment. This has to do with differences
in tastes and differences in attitudes towards risk.
Assuming that we are
all behind a veil of ignorance and do not know what kind of tastes we have, a
just society would respect free choice about lifestyle and would minimize
victimization due to peoples' different tastes and different attitudes towards
risk. A just society should also strive to reduce opportunities for law
offences (such as corruption) that attract risk-loving people to commit the
offences and then punish them severely. In other words, a society that
provides a 90 per cent success rate for an attractive (tempting) criminal
offence and hands out very stiff punishment is considered less just than a
society that offers a 1 per cent success rate for the same criminal offence and
hands out a less stiff punishment. I I
Proposition 7
A just society should not discriminate against people because they
happen to have different tastes or different attitudes towards risk.
Proposition 8
Given the same deterrence effect, improving the chances of catching
and convicting a law offender while reducing the severity of the penalty will
make the society more just. This is desirable as long as the benefit of the
improved justice is greater than the cost of improving the chances of
convicting an offender. A corollary of this proposition is that a low chance
of conviction coupled with very severe penalties is not as just.
5. APPLICATION I: THE CONCEPT OF EXPLOITATION

AND EQUALITY OF OPPORTUNITY
Karl Marx in his Capital propounded a theory of surplus value and
argued that a capitalist society is unjust because capitalists expropriate value
47
created by labor. The reason why they could do this, according to him, lies
in private ownership of capital. According to our analysis, and accepting
his theory of surplus value of labor for the moment for the sake of argument,
if private ownership of capital were arbitrary his argument would be valid.
If, however, capital is not arbitrarily assigned to people, and everyone has
the same opportunity to accumulate capital and run a business in a free and
open market, then Marx's theory of exploitation would be invalid. Rather
than ascribing exploitation to the ownership of capital, our theory of justice
would imply that exploitation should be ascribed to unequal opportunities.
Those who through no merit of their own enjoy more or better opportunities
than others are the exploiters. Those who through no fault of their own
suffer from a lack of or diminished opportunities are the exploited.
It may be argued that some people are born to belong to the capitalist
class, while others are born to belong to the laboring class. Equal
opportunity, it is held, does not exist in the capitalist society. This may
well be the case, but if this is the case, injustice is still attributable to unequal
opportunities rather than to the ownership of capital.
Completely equal opportunities for all is very difficult to achieve,
given the vested interests now prevalent in all real societies. However,
following Rawls' dictum and forgetting our identities and our ownership or
lack of wealth, equal opportunities would require at least the following
conditions:
non-inheritance of wealth, status, and power implying a 100 per cent

inheritance tax and an absence of caste or class distinction for all newborns;12
equal opportunities for nurture and for education for all children, \3
freedom to participate in all markets as suppliers or as consumers;
equality of all before the law.
These conditions ensure that everyone have the same initial conditions
to start their lives and that they face the same rules of the game throughout
their lives. The concern for unequal inheritance is shared by many famous
economists and intellectuals, including John Maynard Keynes:
Since the end of the nineteenth century significant progress
towards the removal of very great disparities of wealth and
income has been achieved through the instrument of direct
taxation-income tax and surtax and death duties ... [Carrying this
process much further has been deterred] mainly, I think, by the
belief that the growth of capital depends upon the strength of the
motive towards individual saving and that for a large proportion
48
of this growth we are dependent on the savings of the rich out of

their superfluity ..... [U]p to the point where full employment
prevails, the growth of capital depends not at all on a low
propensity to consume but is, on the contrary, held back by
it... .. [I]n as much as an increase in the habitual propensity to
consume [caused by a fiscal policy of heavy death duties] will in
genera1...serve to increase at the same time the inducement to
invest, the inference commonly drawn is the exact opposite of the
truth ..... This particularly affects our attitude towards death duties;
for there are certain justifications for inequality of incomes which
do not apply equally to inequality of inheritances (Keynes, 1936,
pp.372-374).
The elimination of inheritance to many is a radical idea. Some may
think that being allowed to accumulate and to leave bequests will not only
satisfy an inherent human instinct but will also provide an important
motivation for people to invest and to work. The desire to accumulate a
bequest for children, however, should be reduced if, through government
provision of equal nurture and education opportunities, parents are assured
that their children will not be disadvantaged because no one is enjoying a
headstart over others. The concern about blunting an important drive that is
potentially important for human progress may also be misplaced, to the
extent that historically many men and women of achievement made their
contribution entirely out of their quest for expanding human knowledge, a
desire for creativity, and an urge to overcome nature's constraints to human
freedom. Musicians like Mozart and Beethoven, scientists like Newton and
Einstein, mathematicians like Euclid and Von Neumann, artists like Van
Gogh and Leonardo da Vinci, even entrepreneurs like Bill Gates and Alfred
Nobel, make their achievements not because they have children to whom
they want to leave a huge bequest. 14 Indeed, if there is the assurance that
one's children have equal life chances compared to others people may be free
to pursue their own interest. As a result there may even be more Mozarts,
more Edisons, and more Einsteins.
Institutionally provided "equal opportunities for nurture and for
education" does not imply the elimination of parental responsibilities for
loving care. Parents can continue to give all the love they can, but they will
not be inhibited by the need to leave a bequest for their children in pursuit of
their own life goals.
49
6. APPLICATION II: CRIME AND PUNISHMENT

Applying the principle of non-arbitrariness to the study of crime and
punishment, we can say that crimes are unjust, and that laws, an effective
judiciary and a penal system that deter crimes contribute towards
establishing a just society. Crimes are unjust because they arbitrarily
redistribute welfare and increase residual risks for everyone. Laws,
judiciary, and punishments that deter crimes make a society more just
because they reduce residual risks.
Applying the principle of non-arbitrariness to the study of crime and
punishment, there is a case for the judicious application of corporal
punishment. Unlike imprisonment which tends to have arbitrary spillover
effects on innocent people, corporal punishment is essentially personal.
Prison terms take parents away from their children, husbands away from
their wives, sons and daughters away from their parents. Prison terms take
away the opportunity for the offender to earn an income, and impose the
burden offeeding, accommodating, and caring for the offender on society.
To the extent that the offender's identity is revealed he/she and his/her
family members are often disgraced and discriminated against by others.
This disgrace or discrimination is over and above the punishment handed out
by the judge. The degree to which a person hurts from the disgrace
depends on his psychology, which varies from person to person thus
rendering the "extra-punishment" arbitrary. Our theory of justice suggests
that an offender's identity should not be disclosed, but the severity of the
punishment should be adjusted to a level high enough for it to serve as a
deterrent. Formal, judicially given punishment should shoulder all the
responsibility to serve as a deterrent and should be as severe as necessary for
effectiveness. Informal, non-judicially given punishment like disgrace or
discrimination should not be used as a deterrent-not because the latter is
ineffective, but because the latter is inherently arbitrary. IS
In societies that place value on human dignity and morality, corporal
punishment is often considered uncivilised and cruel. There is also the
concern that if corporal punishment has to be commensurate with the
severity of the crime, excessive use of violence against a human being will
sometimes be inevitable. Actually, corporal punishment is not necessarily
more cruel than imprisonment. The psychological damage of long prison
terms has not been adequately understood. What is worse, financial
considerations mean that the administrations of most prisons cannot prevent
an inmate from being bullied, mugged, molested, or even murdered by other
inmates. This is certainly potentially more inhumane than judiciously
applied and medically supervised corporal punishment. Moreover, the
severity of corporal punishment does not have to be positively related to the
50
physical damage or impact done by a cane, a whip, or other penal gadgets.

It can be positively related to the number of times the punishment is applied
over an extended period of time. Thus, for example, a minor theft may
warrant two whippings. A more serious one or a repeated offence may
warrant two whippings per week for four weeks. A robbery may warrant
four whippings per day for a month.
The case for corporal punishment based on justice grounds is that much
stronger considering that the cost to different individuals for the same prison
term may well be quite different. A single parent who has a two-year old at
home and has a regular job may find his and his family's life shattered by a
six-month prison term and the loss of his job. Someone else who is single
and has never had a job over the last ten years may find the six-month prison
term "a piece of cake. The abhorrence for physical pain, on the other hand,
is universal. 16
II
7. APPLICATION III: LABOR MARKET AND SOCIAL

SECURITY
In some countries there exist laws that prohibit discrimination based on
sex or race, discrimination against people with certain disabilities, and
discrimination against older workers.
Using the ex ante, Rawlsian
approach discrimination based on sex or race is unjust because individuals
behind a veil of ignorance are arbitrarily subjected to discrimination as they
are selected by nature to fall into a race or a sex category. However, it
should be noted that discrimination against older workers belongs to a
different category because old age happens to everyone who lives long
enough. If jobs are scarce and promotion prospects are scarce, then
mandatory retirement, -which is considered a form of age discrimination,
may equalize lifetime employment opportunities among all citizens. If
everyone behind a veil of ignorance prefers such a scenario mandatory
retirement will be consistent with justice. However, mandatory retirement
for a much more capable person in favor of a younger, far less capable
person may not be in the social interest. A mechanism for dispensing with
mandatory retirement under pre-specified circumstances is not arbitrary and
thus may also be just.
In order to achieve non-discrimination in the labor market,
institutionally there has to be sufficient incentives for people not to
discriminate. Women used to be and may still be discriminated against
because the expected cost of hiring women or their productivity may be less
favorable than that for men because they may become pregnant and may
51
need maternity leave. Older people may be less favored if the cost of
providing health insurance or the expected cost of providing for retirement
benefits is higher for older workers than for younger workers. Physically
or mentally handicapped people may be less likely to be considered for work
if employers find them generally less profitable to hire compared to other
workers. Legislating against discrimination generally comes to no avail
because in a market economy successfully surviving competition requires
firms to be lean and to minimize cost. Imposing heavy penalties on some
employers who are caught in a discriminatory act when competition forces
all employers to engage in discriminatory behavior when they have the
opportunity is unfair and unjust (corollary of Proposition 8). This suggests
that providing financial incentives that offset the inherent unattractiveness of
women, the disabled, and older workers (other things being equal) is just.
In sheltering employers from the higher costs of hiring women, the
handicapped, and other disadvantaged groups, state-provided social security
will reduce discrimination in the labor market. At the same time it may
foster fair competition among firms, to the extent that the social security cost
burden is more evenly distributed among firms. In the People's Republic of
China state and collective enterprises with a long history are now
disadvantaged compared to newer private and foreign-funded enterprises
because they are burdened with a heavy bill for retirees' benefits. As a
result their ability to compete on the basis of merit is compromised. From
another perspective state-provided social security is a direct application of
the insurance principle, providing a safety net where private insurance fails
to provide the necessary protection. However, social security should not be
meant to be vertically redistributive as this would blunt the working of the
principle of merit. 17
8. CONCLUSIONS
In the foregoing we have argued that the Harsanyian-Rawlsian, ex ante
concept of justice is the only concept of justice that is "institution-relevant,"
and have examined how principles of institutional design can be derived and
applied from this concept of justice. In concluding this chapter, it is useful
to emphasize that this concept of justice is itself derived from the
assumptions of rationality and fairness. It is also useful to note that the
theory is consistent with a large degree of autonomy at the individual level
and with the libertarian ideal of a minimal state, in contrary to what some
critics of the Rawlsian theory of justice believe. 18
Our distinction between fundamental justice and incremental justice
adds to the axiomatics about the concept of justice, an excellent survey of
52
which is found in Kolm (1994), who has distinguished between direct justice
and indirect justice, and discussed the Aristotelean distinction between
distributive justice and compensatory justice, as well as various logical
issues arising from or underlying the concept of justice. We believe our
newly introduced distinction is useful, and has helped us avoid unnecessary
controversies. In response to Aristotle's assertion that "justice is equality"
Kolm (1994, p.971) had asked: "why is justice equality?" We provided an
answer in suggesting that equality can be interpreted as equality in the
position from which people make judgments about what is good and what is
bad social choice--i.e., impartiality, or everybody being behind a "veil of
ignorance." The rationale of this hypothetical exercise is ex ante welfare
maximization through optimal choice of institutions.
An important advantage of the ex ante approach to social welfare
maximization is that it avoids the "incessant quarrelling" and "uncertainty"
about each act's consequences in the absence of prior agreement of rules and
institutions that Mill (1972, pp.761-764) noted. Sen (1995) had stated that
"To try to make social welfare judgments without using any interpersonal
comparison of utilities, and without using any nonutility information, is not a
fruitful enterprise." (p.8) This is certainly true with respect to the social
ranking of alternative outcomes, that some practical circumstances will
require.
However, any resulting social choice will still likely be
controversial. On the other hand with ex ante welfare maximization of
"the" individual (all individuals are identically situated ex ante) under a veil
of ignorance there should be no controversy.19
We maintain that the eight principles of just institutions are derived
logically by deduction from the basic premises of fairness, rationality, and
aversion to large risks. Without denying Arrow's point that real life
persons have different backgrounds and are unlikely to have common views
about what is just and what is not when incremental changes to real life
situations are under consideration, we maintain that we are likely to share
common views about fundamental justice. Indeed, the assumptions of
rationality, fairness, and aversion to extreme risks dictate the principles of
just institutions as described above.
Failing to make the distinction between fundamental justice and
incremental justice is the reason behind much unnecessary controversy. As
we explained, given the diverse background and interests of different
individuals there can never be concensus over incremental justice. The
United States will not do justice to its citizens by opening its door to free
immigration, even though such a policy will be seen to be just by many
others. Redistributing incomes from the rich to the poor, similarly, will
please many people but it ignores the reasons behind the existing distribution
of incomes. It may be regarded as arbitrary because freely choosing,
Institutional Foundations/or a Just Society
53
rational human beings behind a veil of ignorance may not approve of such ex
post redistribution, even though they would all rationally approve of
instituting a safety net to reduce ex ante risks.
While the concept of fundamental justice is linked to the HarsanyianRawlsian hypothetical proposition of situating everyone behind a veil of
ignorance, it is still relevant to the real world. The eight propositions are
all relevant to the world and provide clues as to how our institutions may be
improved even though they do not say anything about incremental justice or
the merits of or demerits of an ex post welfare redistribution.
The principles of just institutions are consistent with a high degree of
autonomy. Indeed, to the extent that individuals are assumed to value
freedom and autonomy, institutions that limit freedom and autonomy
unnecessarily will not have passed the ex ante test for justice. Of the eight
principles described above, the principle of equal opportunity has been held
to be inconsistent with autonomy (Fishkin, 1983). According to Fishkin,
there is a "trilemma" and inherent incompatibility among three important
principles: the principle of merit, the principle of equality of life chances,
and the principle of autonomy of the family. He cited the case of a society
that is dominated by a warrior class and noted that "fair competition"
according to the principle of merit would inevitably favor the children of the
warrior class at the expense of others. Equality of life chances would
appear, then, to require state interference into the rearing of children, which
would mean a loss of family autonomy (pp.30-43). Without disputing the
logic of Fishkin's discussion, it must be pointed out that the merit of the
Rawlsian justice concept lies in providing an approach towards evaluating
and designing institutions. Rather than defining "the" just society and
distinguishing it from unjust ones, the Harsanyian-Rawlsian approach offers
a way to differentiate "Rawlsian improvement" from "Rawlsian
deterioration" in the same way that the Pareto efficiency concept allows us to
tell "Pareto improvement" from "Pareto deterioration." Application of the
Rawlsian justice concept does not, therefore, require perfect equality of life
chances. Reducing the inheritance of wealth, status, or political power,
state provision of resources for nourishing and educating children, fair and
open competition, a healthy safety net provided through a carefully designed
social security system, better laws and a better penal system will have gone a
long way towards establishing a just society.
54
NOTES
2
3
7
8
9
10
11
John Stuart Mill made a similar point when he wrote: "human happiness is the sole end
of human action, and the promotion of it the test by which to judge of all human
conduct; by whence it necessarily follows that it must be the criterion of morality, since
a part is included in the whole." (Mill, 1969, p.234)
lowe Prof. Yew-kwang Ng for pointing this out to me.
This is a departure from the "maximin" "Rawlsian utility function" discussed in the
literature. As pointed out by Arrow (1973, p.251) and noted by Posner (1981, p.\OO)
the maximin principle that gives value only to the utility of the worst outcomes in the
utility distribution implies strange results. Aversion to extreme risks is consistent
with the double-hump utility function as discussed in Friedman and Savage (1948).
The ex ante approach to welfare maximization is obviously endorsed by Mill. In a
letter to George Grote, Mill argued that "human happiness, even one's own, is in
general more successfully pursued by acting on general rules, than by measuring the
consequences of each act." (Mill, 1972, Vol. XV, pp.76l-764)
A modem example
of this approach can be found in Garratt amd Marshall (1994), which described a
"contract theory of public finance of college education" in terms of ex ante welfare
maximization. The logic of this approach is underscored by an interesting question
raised by Wasserman (1996): should we divide something evenly among everybody or
should we give the total to the lucky one who wins a fair lottery--given that the sum of
the values of the divided parts may be much less than the value of the total.
The distinction between ex ante and ex post judgments is related to but different from
Sen's (1995) distinction between judgement over "decision mechanism" and "social
welfare judgments." The ex ante approach to social welfare maximization, as
discussed in this paper, and judgments over "decision mechanisms" as referred to by
Sen, are common in that they are both not concerned with realized utilities or welfare.
They are different in that the ex ante approach is concerned with expected utilities,
while Sen's discussion about decision mechanisms is concerned with the satisfaction of
formal axioms such as consistency.
If there is cardinal measureability of utility and utility can be compared, one could
simply add up the utilities and seek the social state with the biggest number. But
Arrow did not assume cardinal measureability and did not assume interpersonal
comparability of utility.
This is defined as "Pareto risk efficiency" in Ho (1981) in contradistinction to Pareto
efficiency which is defined in respect of ex post utilities of different individuals.
Sen (1992) notes the differences inherent in men in terms of the capability to convert
primary goods to substantive freedom. Thus he argues that a theory of justice must
take adequate note of such differences. (p.148)
Here we refer to equality of life chances in the ex ante sense. Affirmative actions are
incremental and thus not part ofthe implications here.
Just laws and just punishment constitute only one component of "institutions."
They
are given special attention because, unlike a free market economy and a social safety
net, they are not implied by the other propositions.
This does not mean that spending more on improving the detention rate while reducing
the penalty (thus preserving the same deterrence effect) is always justified. In
principle justice should be pushed only to the point where its marginal benefit is equal
to its marginal cost.
12
13
14
15
16
17
18
19
55
100 per cent inheritance tax is not recommended in the absence of the other conditions.
If the government can ensure equal nurture and education for all children and there is
equality before the law, then parents will be more ready to accept zero bequest.
Moreover the inheritance tax should not rule out gifts of an emotional nature.
Plato's Republic suggested not only that the birth and upbringing of children should be
done in common but also that children should not know who are their true parents, just
as parents should not know who are their offsprings. Such an arrangement was
proposed apparently as a means to ensure equal opportunities for nurture and for
education.
Bill Gates expressly says that he will not leave a large bequest to his heirs in a
newspaper column. See Hong Kong Economic Journal, October 8, 1996.
There was a case in Hong Kong several years ago wherein a university student was
convicted for shoplifting. The formal punishment was modest, but the act became
front-page headline news in several local newspapers. The poor girl, unable to face
the disgrace, committed suicide.
The abhorrence for physical pain is unlikely to be equal among different people. The
degree of variation, however, is assumed to be acceptable.
Redistribution is not impermissible in a just society. Some degree of redistribution
should be agreeable to rational individuals behind a veil of ignorance. See
Proposition Four.
Nozick (1974) represents one of the foremost libertarian critiques of Rawls. Nozick's
interpretation, as correctly pointed out by Kukathas and Pettit (1990), is not a correct
representation of Rawls, even though Nozick provided "the outline of a libertarian
alternative, but not to undermine Rawls's theory." (p.91)
Using a somewhat different approach, Kolm (1996) also proposes to adopt "the general
philosophy of the the definition of an egalitarian ideal with priority of unanimity," the
essence of which lies in arrangement such as the following: "prefer a more equal
allocation except if everybody opposes it, and a less equal allocation if everybody
prefers it." (p. 161)
Part 2
MICROECONOMIC RISK MANAGEMENT
Risk is a fact of life. Yet the social cost of risk is very much subj ect to
social management. Human beings face all kinds of risks. On the micro
level, there are, among others, the risks of being hit by traffic accidents, falling
sick, being victimized by criminals or being treated unfairly, having money
deposited in a bank that fails, and living older than retirement provisions have
been prepared for. Chapter 5 looks at the case of protection against health
care costs. Chapter 6 looks at the case of protection against litigation costs.
Chapter 7 looks at deposit insurance. Chapter 8 examines the problem of
aging and public pension design.
Chapter 5
HEALTH CARE DELIVERY AND FINANCING:
IN SEARCH OF AN IDEAL MODEL
There are three models of health care delivery and financing: the
market model, the professional model, and the bureaucracy-dominated
model. The National Health Service of the UK and the Hong Kong
government-funded health care system represent the professional model,
although both are supplemented by the bureaucracy-dominated model
(through the Department of Health) and private suppliers. The US system
is predominantly market-based. The Canadian system, on the other hand,
is bureaucracy-dominated. Regardless of the which model one follows, the
incentives have to be right in order to achieve efficiency and effective
protection for the public. This chapter will seek out the basic features of
such a system.
1. INTRODUCTION
There are essentially three models of health care delivery and financing.
The first is the market-driven and administratively decentralised "survival of
the fittest" model (or "the market model").
The second is the
professionally dominated "social welfare maximization" model (or "the
professional model.") The third is the bureaucracy-dominated model (the
"Niskanen model"). These three models seldom apply in pure form in the
real world. In particular, it is not possible to demonstrate that the health
care system of any particular country fits the "Niskanen model" very well,
because no bureaucrat will declare that he pursues his own self interest while
in public office. While the Canadian system was criticised for being
dominated by bureaucrats to the detriment of both patients' and doctors'
interests,l it was also hailed as a possible solution to the under-insured but
costly system of the US. 2
Under the first category are included both the more traditional fee-forservice model and the managed care model, with the former often
complemented with third party insurance. Under the second category are
60
various designs which vary in quality and effectiveness but which are all
aimed at maximizing social welfare as perceived by welfare-minded
professionals and bureaucrats.
The institutional framework allows
professionals much leeway to act independently but there is little room for
them to profit for their professional decisions. Under the third category is
the bureaucracy-dominated, self-interest maximization model (Niskanen,
1971) under which the welfare of medical service suppliers and that of
patients are subordinated to the self-interest or convenience of regulatorbureaucrats. In the literature on health care reform and in practice, the first
two models are always seen to be competing with each other in terms of
social welfare maximization. The market driven model is not by design
social welfare maximizing, but many economists still believe that the
invisible hand of the market will be more effective in enhancing social
welfare than one that sets out to maximize social welfare in the first place.
The third model is not meant to compete with the other two models in terms
of social welfare maximization, but does enjoy some advantages, as
discussed below.
Section 2 and Section 3 will outline the central features of the market
model and the professional model respectively. Section 4 will discuss
briefly the bureaucracy-dominated model. Section 5 will explore how the
best features of the market model and the professional model can be
achieved through a unique form of government intervention that can be
described as "excessive burden insurance." We shall see in the next
Chapter that this principle of excessive burden insurance is equally
applicable to the case of legal aid, and is an important direction that civilised
societies of the world can take to improve social welfare.
2. THE MARKET MODEL

The U.S. health care system of today can be said to be the prototype of
the market model. This is not to say that the U.S. governments, federal, state,
or local, do not interfere with the medical care market. They do, in fact in a
big way.3 The distinguishing feature of a market model for health care is
that the market is given the dominant role in determining how much and
what to spend on in health care, because market forces are believed to lead to
the most efficient outcomes. Patients are supposed to fare better when they
are given the choice to select their doctors, their insurers, and their
pharmacists. Doctors, therapists, and pharmacists are supposed to give the
best services if they are rewarded according to the services that they provide
at market-determined rates.
Health Care Delivery and Financing: In Search of an Ideal Model
61
Following the market model, the United States has a sizeable

population without any health insurance coverage. 4 This is quite unlike
most other developed countries, where citizens are all under some kind of
protection, with or without direct funding from the government. The
underlying assumption is that while the Government should insure the poor
(Medicaid) and the old (Medicare), those who are neither poor nor old
should have the choice to buy health insurance or not. Unfortunately, not
all poor are entitled to Medicaid, and not all old enjoy the same kind of
care,5 and not all among the uninsured voluntarily opted for no insurance.
By choice or otherwise, we know that "the uninsured have less access
to care, use less care, cannot obtain specific health care services, are twice as
likely to be hospitalized for conditions that can be averted by outpatient care
(such as acute asthma attacks), and have a higher risk of death when they go
to the hospital. ,,6
Among those who are insured, most are now covered in "managed
care" plans. The hallmark of such plans is prepayment or "capitation."
The caregiver is paid when an enrollee enrolls in a plan, and not at the time
when he actually uses the services. Such an arrangement has the obvious
advantage of giving caregivers the incentive to save costs. But this
incentive to save cost can be contradictory to the interest of patients.
Obviously, caregivers are constrained in the extent to which they can
sacrifice patients' interests. If they consistently sacrifice patient interest,
they will fail to attract enrollees. Yet, according to Kuttner (1998) Health
Maintenance Organizations (HMOs) may give the sickest people poor
service because driving such people away is in their interest.
In the United States, nearly three out of four HMOs are for profit.
Some 62 per cent of HMO members are enrolled in for-profit plans in 1998,
as compared with 12 per cent in 1981. There are all kinds of HMOs.
Some opted to be generous and tried to target at the young and healthy, like
the Oxford Health Plans. Others, like the U.S. Healthcare, opted to be
stingy and expose their doctors to financial risks if caring for their patients
become too expensive. The financial performance of these HMOs varies
greatly from one to another. The fact remains, however, that enrollees
ultimately have to test their luck. Doctors, too, are highly subject to the
vagaries of the market. Meanwhile, managed care under market auspices
has produced a "double paradox": "The more patients chafe under the
constraints of utilization controls, the more they demand a choice of
doctors-not realizing that the various doctors affiliated with a plan have
similar or identical financial incentives to constrain costs. And the more
plans try to offer a choice, the further they stray from the system-wide
integration, prevention, and case management that are the supposed
advantages of HMOs." (Kuttner, 1998)
62
3. THE PROFESSIONAL MODEL

The Hospital Authority (HA) in Hong Kong is the prototype of the
professional model. The HA in 1999 manages over forty hospitals, which
range widely in size and scope of services. Each year the HA is given a
budget by the Hong Kong Special Administrative Region Government.
The budget is allocated to each hospital according to some formula that takes
into consideration the volume and composition of caseloads of each hospital.
Each hospital has a Hospital Chief Executive who is an experienced doctoradministrator. The HA itself is run by professionals who are hired on terms
that are set independently from the Hong Kong SAR civil service. The
British National Health Service (NHS), especially during the period prior to
the recent market-oriented reforms, was another fine example of the
professional model. Doctors are paid a salary and are not according to the
volume of their work.
The underlying principle behind the professional model is that the
medical profession is in the best position to serve the interest of patients,
provided that the profession is given the latitude to act independently and
paid a salary commensurate with the returns expected from investing in
training. Medical professionals are assumed to have the integrity to engage
in ethical practice. The biggest advantages of the professional model are
two. One is that it is free from the problem of "supply-side moral
hazard"-doctors will not, given their salaried status, knowingly supply a
service that does not serve the patient's interest. The other key advantage
is that it puts the medical professional in center stage. His decisions are not
circumscribed by bureaucratic interference, and are not swayed by market
forces. The main objection against the professional model is that it may
limit the choices open to patients, and that, not being subjected to the forces
of the market at all, caregivers may not be sensitive to the needs of patients.
Without the goad of competition, services may not improve, and costs may
be higher than necessary.
The professional model in practice turns out to be very attractive to
consumers of health services. Surveys in Hong Kong and in the U.K.
suggest overwhelming support and general satisfaction with the system.
Jinks, Pharm, and Shayegan-Salek (1997) described the NHS as "a proud
British achievement, the expression of over 40 years of a sustained
commitment to the ideal of providing 'effective health care as a public
service to all who need it.",7 Ho (1997a) found that Hong Kong citizens
were in general quite happy with the HA system, and many indeed were
prepared to pay more taxes in return for an even better service.
Both the HA in Hong Kong and the NHS in the UK are predominantly
funded by the general tax revenue. User charges are nominal or non-
63
existent, and this is putting pressure on the system to reform. Still, as a

professional model, the HA in Hong Kong is administratively independent of
the government. While the NHS is under the direct jurisdiction of the
Minister of Health, medical professionals are deeply involved and are
heavily relied upon both in the administration and in the delivery of health
services. Although the NHS has undergone a major reform through the
nineties trying to introduce some element of competition the general
consensus is that there was little overall measurable change. In particular,
the professional culture remained intact. According to Le Grand (1999),
"those working in the NHS-whether doctors, nurses, manages, or ancillary
staff. ... felt that they were engaged in the provision of a public service, with
provider relationships (both with each other and with their patients) based
more on considerations of mutual trust than on adversarial competition."g
4. THE BUREAUCRACY-DOMINATED MODEL

There is a fine line and yet material difference between the
bureaucracy-dominated model and the professional modeL Obviously no
bureaucracy-dominated healthcare system can work without significant input
from medical professionals. The conceptUal bureaucracy-dominated model,
however, constrains the medical professional so much so that professional
autonomy-a dearly treasured aspect of professional practice and the basis
of professional self-respect-is severely circumscribed. The Canadian
health care system, under the duress of fiscal pressures, had succumbed to
bureaucratic interference to a degree that it could be described as an example
of bureaucracy-dominated model. 9
For many years the Canadian health care system had been the envy of
Americans. 1O It had achieved universal access to high-quality health care,
and the resources committed, in terms of the percentage of the GDP devoted
to healthcare, are far less than that of the United States. The Canadian
system is quite a unique one, in that public financing of health care goes
hand in hand with the prevalence of private practice.
The Canadian system had been heavily supported by the federal
government. As the federal government went more deeply into debt,
however, federal funding for health care expenditures was sharply reduced.
In Ontario, under the Savings and Restructuring Act, physicians were at the
mercy of the minister of health, who can "unilaterally close hospitals, set
physicians' fees and tell physicians where they can work and what services
they can provide. He can remove at will their right to practice medicine in
the province. He can view confidential medical records and disclose the
information for any reason. Government inspectors can seize medical
64
records without a reason, a warrant, or the patient's consent. Inspectors

can ... rescind payment after the fact for physician services deemed to have
been 'unnecessary. ",11 Patients complained of long waiting times for
emergency care and for specialized surgical services. It is not true,
however, that bureaucrats are necessarily insensitive to patients' needs.
The main advantage of the bureaucracy-dominated model of medical
care is that it can be fiercely expedient for achieving certain policy goals
identified by the bureaucracy. The fear is that it may be insensitive to the
aspirations of the medical profession and the needs of patients. While this
fear can be misplaced, because the bureaucracy may well be enlightened and
sensitive,12 too much is left to chance so that in general neither consumer
(patient) groups nor the medical profession is satisfied with it.
5. TOWARDS AN IDEAL SYSTEM

We now know that an ideal health care system must have certain
ingredients. First and foremost, health care services provided under the
main health care plan must be heavily subsidized and yet priced in such a
way as to provide the right incentives for both suppliers and consumers.
That is, suppliers of health services must not have the incentive to oversupply or to under-supply services, while consumers should have the
incentive to take good care of their own bodies and not to over-use the
system. Second, consumers must be protected from excessive burden.
That is, medical care expenditures needed for body "maintenance and repair"
must not be so costly as to plunge the consumer into financial difficulties.
Third, for-profit private sector medical practice and hospitals should operate
against a background of an adequate and sound publicly-funded,
professionally-run medical care system. This will ensure that all private
practices will provide quality care or such particular and specialized services
that they are normally not covered by the public plan-because otherwise
patients will leave them.
By nature, medical care is costly. Modem medical care requires
highly precise and specialized equipment, well-trained professionals, and
knowledge-intensive drugs. Without subsidies many people may be denied
the needed medical care. Voluntary private insurance does not work
because private insurers tend to reject those who need medical services the
most. Mandatory insurance may work but there are two catches. One is
that the poor may still need to be subsidized. The second is that charging
fees to the insurer could lead to over-supply of medical services ("supplyside moral hazard"). Without an appropriate fee charged to consumers,
65
moreover, consumers are likely to over-use services and less likely to take
good care of their health ("demand-side moral hazard").
The logical conclusion from this argument is that a fee reflecting the
direct cost of providing the service, exclusive of any overhead cost, should
be charged to consumers. Such a fee would be neutral to suppliers, because
on the one hand suppliers will not under-supply services since any extra
costs arising will be covered, and on the other hand they will not over-supply
since no extra profit can be gained. Private health service suppliers will
need a lump-sum transfer from the government to cover their overhead costs.
This arrangement will allow the best of professionalism manifest itself.
Even though households are held responsible only for the direct costs
of medical care the cost of medical care may still be too large for them. To
protect them from excessive burden, we can set up a spending limit
amounting to, say, six per cent of the mean household income for a
household of average size. Larger size households will have a larger
threshold and smaller households will have a smaller threshold. Once the
threshold has been exceeded, all the excessive spending on permissible items
will be taken up by the government.
In some countries private hospitals are under-utilized while public
hospitals are over-utilized. The excess capacity in private hospitals does
not relieve the government of building more capacity among public hospitals.
This is a direct result of the vast gap between charges in public hospitals and
those in private hospitals. To eliminate such waste, it is necessary to
equalize the charges. In particular, the charges prevailing in Hong Kong's
public hospitals should be raised, while the charges prevailing in Hong
Kong's private hospitals should be reduced. Under my proposal, private
hospitals will be given the option to join the Hospital Authority system. If
they join, they will be committed to charging patients standard fees for the
standard services on a list. They will receive a lump-sum payment per year
based on a formula reflecting their capacity and the range of services
provided. They will receive user-charges direct from patients up to their
yearly spending threshold and from the government after they have breached
the thresholds.
Private hospitals may charge full fees independently if they do not
receive any lumpsum subsidy from the government. All private hospitals
can also charge fees independently for services which are not on the
"standard service list."
Sweden has a similar system as proposed in this. chapter. From June
1999 Sweden has a spending ceiling of 900 krones (about US$1 00) per year
for care and 1800 krones (about US$200) for drugs per person. The
Swedes never need to worry about excessive health care expenditures. Yet
Swedish health care expenditures as a percentage of the gross domestic
66
product has remained stable or has fallen, while most countries experienced
an increase.
One might question the wisdom of setting a uniform yearly spending
limit for the entire population. In particular, why is it that a very rich
person should be entitled to the same spending threshold and thus receive the
same subsidies from the tax-payer as an average person? Should a poor
person be subject to a smaller spending threshold or be exempted from any
threshold altogether? Once it is realized that "the tax-payer" consists of
none other than the richer members of the community the apparent inequity
of allowing the rich to benefit from excessive burden insurance disappears.
As for the poorer members of the community, it is possible to give them a
smaller threshold at, say X per cent of the standard threshold. I would also
propose to charge these poorer patients fees that are discounted X per cent,
so that regardless of rich or poor, everybody with the same health care needs
would progress towards exhausting the annual spending limit at the same
pace.
The universal access principle or principle of universality discussed
herein contrasts with the "Able Pays More" principle that are sometimes
advocated by some politicians. On the surface, universal access to
subsidized health care is unfair. However, when a "rich" patient gets
subsidized care, the implicit transfer that he gets is sourced either from
himself or from other "rich," tax-paying, individuals.
There is no
distributionally perverse transfer from the poor to the rich. There is only a
transfer from the healthier taxpaying individuals to the less healthy
taxpaying individuals. It is not apparent that this is undesirable in any way.
Indeed, because universality is administratively simpler than limiting access
to subsidized care to the poor, it is an eminently sensible principle in the
conduct of public policy.
Another important consideration that we must bear in mind is that
while few would disagree with the general idea that those with a greater
ability to pay should pay more, the "able" is not indefinitely able. There
will come a point when even the "able" finds it hard to come up with the
resources to support a very costly treatment. Thus there is a need for
protection against excessive burden even for the rich, and for those who have
saved for "the rainy day."
The pitfalls of the "saving for the rainy day principle" do not spare the
Medisave program of Singapore. Under the Medisave Plan Singaporeans
contribute 6 to 8 per cent of their incomes towards the Medisave sub-account
in the Central Provident Fund. 13 Realizing the pitfall Singapore later
introduced the Medishield program to provide catastrophic insurance in 1990.
Another pitfall is that if the accumulated savings are too big the enrollee
67
would be tempted to use the accumulated savings on health services even

when such services have a low value. 14
6. CONCLUSIONS
It is important to point out that any health care system is subject to
some drawback. There is, in a word, no perfect system. We should,
however, find the best practical system. The best practical system must:
be administrative feasible and not too costly;

provide protection against unexpected excessive burden for all;
provide protection for chronic patients;
incorporate sufficient incentives on both the supply side and the
demand side to ensure efficiency so that the overall burden to society
will be minimized;
provide the greatest degree of choice and freedom for patients possible;
allow sufficient autonomy to medical professionals for them to do a
good job;
provide protection for patients against unprofessional practice;
provide room for private health care professionals to operate.
This is not a list of impossible things. Actually, with today's

computer technology we can easily build a system that records the "eligible
health care expenditures of a household" and ensure that no household spend
beyond the "excessive burden" threshold. Any eligible expenditures within
the year beyond the threshold can then be taken up by the government. This
takes care of the first three desirable features.
A key proposition developed in my work on health economics (Ho,
1997a) is that efficiency of health care delivery requires charging patients an
appropriate fee and compensating caregivers at an appropriate rate.
Charging patients appropriately not only will help avoid abusive utilization
of the health care system, but will promote preventive activities and
encourage people to adopt a healthy lifestyle. Charging patients for
standard services according to standard charges means that we need to
compile a list of the eligible health services to be covered and the charge
rates. In practice the charge rates need not be fine-tuned to reflect the
conceptual marginal costs precisely. The key is that they should not be so
remunerative to the supplier that the supplier is tempted to oversupply the
service.
"Seamless health care" can be achieved by covering both primary,
secondary, and tertiary care, and even accident and emergency care, whether
68
supplied by public sector providers or private sector providers, under the

same "excessive burden insurance" plan.
The professional model works best when it is not subject to the sway of
market forces or the influence of the financial motive. Public funding of
health services provides the necessary environment for professionals to work
with autonomy. Still, the "market model" should be given a role to play
too, in those areas of the health care market which are not considered basic.
Consumers should be given the freedom to buy the services that they want at
prices which they agree to pay. Bureaucrats are in the best position to serve
as the overseer to ensure that complaints from consumers receive
independent and professional investigation. They also serve a coordinating
role and act as a bridge among the public, the professionals, and the market.
Nobel Laureate Amartya Sen is right when he argued that an
assessment of inequality in general should go beyond figures on income and
wealth. As he explains, "Quality of life depends on various physical and
social conditions, such as the epidemiological environment in which a
person lives. The availability of health care and the nature of medical
insurance ... are among the important influences on life and death ... " (1995,
p.35) He argued that it was no coincidence that a dramatic rise in life
expectancy occurred in the same decade as the National Health Service of
Britain emerged, i.e., 1941-51. (op.cit., p.12).
Consistent with the same logic, the Director General of World Health
Organization in 1981 explained that "health for all" is a holistic concept
(Roemer, 1993, p.335). Not only does it require universal access to
primary care with adequate referral services to more specialized care, but it
also implies a commitment on the part of the government to promote the
advancement of all citizens on a broad front of development. This,
however, cannot be done through a one-way delivery of services from the
government to the citizens. This has to be predicated on the emergence of a
greater awareness and a sense of responsibility on the part of the citizens to
take care of their own well being. We argue that making citizens pay for
the direct cost of health care is an important element in this strategy. We
also argue that this need not compromise accessibility, provided that we
have in place a system of protection against excessive burden, such as
proposed in this chapter and currently in practice in Sweden. Justice,
equity, and efficiency can go together, while the market, the professional, as
well as the bureaucrat can all have a role to play to further these ends.
Certainly bureaucrats need not be content with acting out the role as
portrayed by Niskanen in his early book.
69
NOTES
1
2
See Arnett, Jerome C., Jr. (1996).

See "Whither a Health Care Solution? Oh, Canada," Businessweek, March 21 1994, 5657. It was hailed again by Dr. Marcia Angell, Editor of New England Journal of
Medicine, as superior to the American "insane" system at the annual meeting of the
British Columbia Medical Association. See National Post, September 4, 2000.
In Fiscal 2000, President Clinton requested a total budget of $400.3 billion for the
3
Department of Health and Human Services, representing a 6.6 per cent increase over
Fiscal 1999. The biggest expenditures are for Medicare (53.6%) and Medicaid
(28.6%) Inclusive of other smaller items, total "mandatory (entitlement) outlays"
amount to some $359.8 billion. In addition, under "discretionary programs" the
Health Resources and Services Administration has requested a budget of $4.1 billion
and runs some 746 community and migrant health centers for low income and
uninsured individuals and families. The budget for the Food and Drug Administration
is not huge, but has a big impact on the health care market through its regulation of
drugs and food products.
4
The proportion of American without health insurance increased from 14.2 per cent in
1995 to 16.1 per cent in 1997, when the uninsured population reached 43.4 million
(See Kuttner, 1999).
5
Part B of Medicare requires voluntary participation through the payment of a monthly
premium.
6
"The Medically Uninsured: Will they always be with us?" New England Journal of
Medicine (the Sounding Board), Vol. 334, no.17, 1103-1133.
7
In Health Care Systems Around the World, edited by M.L.Lassey, W.R.Lassey, and
MJJinks (1997).
Le Grand, Julian (1999) "Competition, Cooperation, or Control? Tales from the British
8
National Health Service," Health Affairs, May/June.
9
With the Federal Government's fiscal position swinging back into surplus in 1999 there
is a good chance that bureaucratic interference with health care will be reduced
noticeably.
lOA formal proposal for health care reform modeled after the Canadian system was put
forward by Senator McDermott and 92 other House Democrats. See "Whither a
Health-care Solution? Oh Canada," Business Week, March 21, 1994.
11
Jerome Arnett: "Ontario's Health Care: a Pox on Doctors and Patients," Asian Wall
Street Journal, 10 March 1996.
12
As Naylor (1999) pointed out, Ontario does have a comprehensive waiting list
management system. When coronary artery bypass graft (CABG) queues grew to
intolerable levels, as happened in 1990 and 1997, the Ministry of Health responded
with major capacity expansions that quickly reduced the length ofthe queues.
13
Those below 35 contribute 6 % up to a maximum of S$360 while those 45 and above
contribute 8% up to S$480.
14
Singapore has set up a maximum for the accumulated Medisave account savings to
contain the distortionary effects. Contributions in excess of the maximum are
transferred to the CPF Ordinary Accounts.
Chapter 6
LEGAL AID AND JUSTICE
In many ways legal aid resembles health care. There is an imperative,

on grounds ofjustice, to provide legal aid and to provide health care to those
who cannot afford it. Both legal services and health services are performed
by professionals whose knowledge about their trade is not shared by the users
of their services. Both legal and health services can be so costly that they may
stretch the limits of users. Schemes to protect users from both the heavy cost
of legal services and that of health services are subject to moral hazard and
information asymmetry problems.
1. INTRODUCTION
Legal aid is commonly seen to be an important cornerstone for a system
of justice in a civilised society. Certainly justice would not be justice if access
to the judiciary process were limited only to those with the means to seek
redress through legal proceedings.
When legal aid was first introduced in the United Kingdom in 1950, it
was designed exclusively for civil suits. However, it was soon recognized
that defendants accused of criminal offences need to be properly represented
in a court of law if society's claim for espousal of justice is to be upheld.
Today, in the United Kingdom, as in Hong Kong, legal aid is more liberally
given for criminal than for civil proceedings. Indeed, in Hong Kong all
people charged with criminal offences who require the services have been
granted legal aid. The means test, passing which is normally required for
civil suits, is routinely lifted by the Director of Legal Aid to make sure that
the defendant has a fair hearing. Similarly, in the U.K., following the
recommendation of the Widgery Report on criminal proceedings (HMSO,
1966), the proportion of defendants appearing on an indictable offence in a
magistrates' court with legal aid rose rapidly, from 20 per cent in 1969 to 80
per cent by 1986.
Legal services is in many respects similar to health services. Like
health services, legal services is performed by professionals who need long
years of training. Like medical care, the outcome of health services is often
72
not clear. One cannot predict success or failure in litigation, just as one
cannot tell for sure whether a surgical operation will be successful or not.
Similarly, very often one cannot tell how much will the litigation costs be, or
even how long the litigation process is going to take. Like medical care,
legal aid is prone to supply-side moral hazard and demand-side moral hazard.
That is to say, lawyers, like doctors, may supply more services than are
needed in order to benefit financially, while users of legal aid, like patients,
may demand more services than social costs/social benefit considerations
justify.
Under most legal aid schemes, applications for legal aid are subject to a
means test as well as a merit test. Today (i.e., year 2000) in Hong Kong the
means test requires that the total annual income and capital assets after paying
the rent for the dwelling unit and an allowance for daily maintenance should
not exceed HK$169,700 (about US$21756). The merit test, applicable only
for civil suits, requires that an applicant must have valid grounds of seeking
justice through the judiciary process and must have a reasonable prospect of
success. The latter can be regarded as a "gate-keeping" mechanism to avoid
abuse.
Because of the similarities between health care and legal aid, the
arguments for excessive burden insurance principle that apply to health care
also apply to legal aid. The idea is that even people with incomes commonly
regarded as high may not be able to afford the expenses required in seeking
redress through legal proceedings. There is a difference though. Whereas in
j}e case of health care a yearly spending limit is perfectly sensible in the case
of legal services probably a much higher, 10-year spending limit would be
more appropriate. Unlike health care, litigation is in general not a regular
need. It would not make sense to limit litigation costs to X per cent of the
annual income. 1 I would propose that one should be responsible for litigation
costs up to half a year's earnings. We would still need the gate-keeping
mechanism in order to prevent demand-side moral hazard.
2. SUPPLY-SIDE AND DEMAND-SIDE MORAL HAZARD

Under many typical legal aid schemes, the lawyers acting on behalf of the
aided persons are in private practice. This is more a result of political
lobbying by a professional body than one of social design. In the United
Kingdom, the Law Society, which administered the scheme until 1988, had
offered a 15 per cent discount on legal aid work to avoid a salaried service.
The fee-for-service mode of operation, however, is widely known to engender
supply-side moral hazard.
Gray, Richman, and Fenn (1999) found
circumstantial evidence that is consistent with the supplier-induced demand
73
thesis. In particular, a rise in the opportunity cost of time, such as an increase

in mortgage business, was found to have a negative impact on unit costs and
the volume of legal aid work, while an increase in the number of solicitors was
found to have a positive impact. Richman, Gray, and Fenn (1999) believed
that the smaller increases in criminal volumes than civil volumes between 1980
and 1995 may also be related to the fact that it is the police and the crown
prosecutor, not lawyers, that decide whether or not to proceed with a criminal
case (p.272).
Supply-side moral hazard is not the only reason that may cause a
misallocation of resources and a run-up in legal-aid-related expenditures. If
users of legal aid services do not bear the cost of using the services, they may
use the services even though the benefits may not justify the costs. Rickman
et. al. (1999) found that the propensity to litigate is much higher among those
who do not have to pay anything than among those who are required to
contribute toward the cost (11 per 1000 as compared with 1.79 per 1000, p.273).
Although there is a gate-keeping mechanism in the sense that an application for
legal aid must pass a test of merit to be approved and gross abuse of the legal
aid system is unlikely, the perception that the legal services are "free" will lead
to excessive utilization of the services. The fact is: even if there is "merit" the
social benefits of proceeding with a case still may not warrant the costs
involved.
3. FEES OR SALARIES?
FEES AND SALARIES?
As long as lawyers are paid on a fee-for-service basis and lawyers make

money from legal aid work, there is likely to be a "principal-agent problem."
Even after 1988, when the U.K. Legal Aid Board took over the administration
of legal aid from the Law Society, we could see the Legal Aid Board as the
"principal" engaging an "agent"-the lawyer-to provide legal services for a
client. Since the interest of the Legal Aid Board and that of the lawyers are
not the same there will be no reason to expect that lawyers will behave in a way
that best serves the interest of the Legal Aid Board. As long as users of legal
aid services pay only a fraction of the cost of such services or nothing at all
there will also be a tendency for over-consumption of the services.
The best solution to the supply-side moral hazard is remunerating legal
aid lawyers with a salary at a rate that fully reflects the professional nature of
the job. Salaried lawyers will consider each job in a professional manner,
much as a technocrat employed in the civil service would. Lawyers hired to
work in legal aid are hired for their belief in the cause of legal aid and their
professionalism. Earning a salary, their decisions and activity in a case will be
money-neutral and market-neutral.
74
Because the cost of litigation is difficult to detennine before hand, even

relatively well-off people-people who nonnally would not qualify for legal
aid, may refrain from litigation. This would mean that real cases of grievance
or injustice may not be attended to, and more important, this means that more
of such cases will occur each year because wrongdoers have reasons to believe
that their victims will not litigate. This is clearly unjust and welfarediminishing.
To contain the problem of demand-side moral hazard and at the same
time to achieve greater social justice, eligibility to legal aid should be extended
to all citizens, and all users should be charged a standard fee for each hour of
legal services used up to some limit. Unlike excessive burden insurance in
health care, however, I propose a ten-year spending limit rather than an annual
spending limit. This will be a much bigger figure, perhaps 60 per cent of annual
income. The main reason is that whereas health care expenditures are regular
expenditures that will occur year after year, litigation expenditures are usually
much bigger and very infrequent. Following the principle of redistribution
and helping the poor, I recommend that the poor should be subject to a lower
spending limit and lower fees. This is much like what I recommend for health
care.
In the United Kingdom, at the initial stage of a potential legal action, free
legal advice and assistance, for up to two to three hours, are generally provided
under the means-tested Green Fonn Scheme. Following the logic of
excessive burden insurance, offering this service free is really not important,
because the expenses are relatively small. What is important is excessive
burden protection. The free service opens up an opportunity for abuse.
Collecting this amount as well as fees for other services will goad citizens into
more "preventive care," as individuals will become that much more careful in
interacting with other parties.
To conclude this section, a direction of legal aid refonn will be to allow
the legal aid department charge clients fees up to a limit. The legal aid
department will use these fees as well as allocation from the government
budget to pay for the salaries of employed legal aid lawyers.
4. PROSPECTIVE PAYMENTS, CONTINGENCY

PAYMENTS, AND LEGAL AID
Just as health refonn proposals are full of suggestions for prospective
payments, for example under the Diagnosis-Related Group (DRG) fonnula that
pay hospitals according to the diagnosis of admitted patients, so the legal aid
literature has recently attracted some discussion about prospective payments.
75
As Rickman et. al. (1999) explained, the introduction of "standard fees" for
criminal cases in Magistrates' Courts in 1993 followed the prospective
payment philosophy. It is, however, fairly complicated, not only involving
different standard fees for different categories of cases, but also allowing
graduated charges based on "the solicitor's report, audited by the Legal Aid
Board, of the work demanded by the case." (p.274) "The solicitor may
additionally claim percentage enhancements to the itemised rates, by
demonstrating that the work was done with exceptional competence and
dispatch, or that the case had exceptional circumstances." (p.274)
The advantage of prospective payments lies in containing costs and
limiting the risks of clients. Lawyers receiving fixed prospective payments
will have no incentive to waste time and money. Clients (the Legal Aid
Department in this case), too, will know with greater certainty how much they
need to spend on the legal proceedings.
As mentioned earlier on the Law Society had been able to use its
influence to avoid a salaried legal aid service. As long as legal aid works
through a private practice system, however, it is unlikely that standard fees can
dominate, because there is considerable diversity in the complexity of cases.
For this reason, it is not realistic to expect prospective payments will help
contain costs significantly.
Another direction of legal aid refonn is related to the introduction of
conditional fee agreements (CFAs). Under CFAs the litigant need not pay the
lawyer a professional fee unless the case is won. If there is nothing to pay
unless the case is successful, one major inhibition for taking legal action when
one feels unfairly treated will be gone. The need for legal aid will then also be
reduced.
One problem with CFAs is that clients with CFAs will still have to pay
for the expenses ofthe lawyer, and in case oflosing the suit, for the costs of the
other party. Because there is always a chance of loss, CFAs can never eliminate
the need for legal aid.
5. CONCLUSIONS
Legal aid has generally been offered on the basis of two tests: the means
test and the merit test. This chapter argues that legal aid, like health care,
should follow the principle of universality. Because legal costs are difficult to
estimate ahead of time and can be quite significant, people who do not quality
for legal aid routinely avoid legal action for financial reasons even though they
have been unfairly treated. This behavior is perfectly understandable but may
not be socially optimal, because it may lead to more wrongdoing.
76
It is true that conditional fee agreements are making legal services more
accessible to the average person, but as pointed out earlier, the worry over
losing the suit and having to pay the legal fees of the other party could be
inhibiting.
Universal access to legal aid, combined with a legal aid service that hires
salaried lawyers as employees and charges clients for services used at cost up to
some limit, will greatly enhance social justice. It will contain supplierinduced demand as well as demand-side moral hazard, and will put the justice
system truly within access of people at large.
If victims of wrongdoing are more likely to litigate, potential wrongdoers
will think twice before they would offend. Less offence will be perpetuated.
Although under the principle of excessive burden insurance legal aid is
available without means-testing, the demand for legal aid services could
actually decline, if the number of offences is reduced. While the universality
principle is followed, the proposed scheme allows the poor to be given a
smaller ten-year spending limit and to be charged at a lower price, just like
what was proposed for health care in the last chapter.
Of course, having a state-run legal aid system that is available on demand
to all citizens does not remove the right of a citizen to engage a private lawyer
to litigate for him. Like medical care, the free market will offer those who can
afford it greater choice. The state, however, should ensure that no one is
denied basic health care and redress through the justice system.
NOTES
Ho (1997) proposed, as the yearly health care spending limit, 6 per cent of median
household income divided by the average number of members in the household for one
individual. The annual spending limit for a specific household would then be this
figure multiplied by the number of the particular household concerned.
Chapter 7
BANK DEPOSIT INSURANCE
In the wake of the Bank of Commerce and Credit (BCC) debacle the
Hong Kong Government, then under British rule, issued a Consultation Paper:
Deposit Protection Scheme (Monetary Affairs Branch, Government Secretariat,
February 1992). Despite expected objections from the major banks the
Monetary Authority under the new SAR Government is revisiting the subject,
and is expected to come up with a decision about introducing deposit insurance
into Hong Kong before too long. This chapter is adapted from a contribution
in Deposit Insurance: Issues and Evaluation, edited by Y. C. Jao and published
The
by the Chartered Institute of Bankers-Hong Kong Centre, July 1992.
argument presented illustrates an important principle ofpublic policy, namely,
that the rational behavior of individuals must be fully considered in the design
ofpolicy.
1. INTRODUCTION
The traditional role of deposit insurance has been mainly to prevent
bank runs and thus to foster stability in the banking system. To the extent
that this role has often been filled by the establishment of an effective lender
of last resort, to whom banks caught in temporary liquidity crisis can turn,
some have argued that there is no need for a deposit insurance scheme. l Yet
deposit insurance continues to serve important functions in a modern society.
It is argued in this chapter that one form of deposit insurance, namely one
that provides full coverage for all demand deposits, 80 per cent coverage for
all savings deposits, and 60 per cent for all other deposits, is likely to bring
the most benefit to a modern society. The precise percentage numbers
could be somewhat modified, but the spirit of full protection for demand
deposits and lesser protection for other kinds of deposits is eminently
sensible.
In Hong Kong "the Government has made it clear that liquidity support
for solvent banks would be forthcoming from the Exchange Fund"
(Consultation Paper, para. 2b). If this is the official policy the Exchange
Fund will then become the official lender of last resort. Granted that the
78
Exchange Fund has at its command considerable reserves and its official
capacity, depositors should have little worry that banks would fail to honour
their commitments on grounds of liquidity. Yet the reassurance by the
Government about the overall health of Hong Kong's banking sector cannot
guarantee that all banks are sound. The statement in the Consultation Paper,
that "The main protection [to depositors] must continue to come from having
a supervisory system up to international standards," (para. 7) is hollow for
the unlucky depositors who were caught in the Bank of Commerce and
Credit (BCC) incident. For them there was no "main protection": they had to
endure a long wait before the first instalment of repayment at 25 per cent of
their deposits. In a typical bank failure, depositors had to wait a long time
to get any reimbursement made possible in the liquidation process which
could last for years.
2. THE SOCIAL BENEFITS OF DEPOSIT INSURANCE

The Consultation Paper argued that a carefully designed deposit
protection scheme could perform two valuable functions:
compensate small depositors either fully or in part in. the event of a

non-systematic failure of any but the largest banks in a banking system;
and
enhance the stability of a banking system by raising the "crisis of
confidence threshold" of the general public.
Actually, this significantly understates the value of deposit insurance.

By providing immediate liquidity to depositors affected by troubled
banks, bank deposit insurance (BDI) may save hundreds of well-run
businesses which may otherwise be directly or indirectly pushed into
bankruptcy or closing down for not receiving money receivable or not being
able to pay money payable.
By providing the assurance that one's own liquidity and that of one's
clients will not suddenly dry up because of bank closures, bank deposit
insurance will improve the investment climate for businesses. Employment,
income, and tax revenue may rise as a result. In the absence of a sound BDI
the costs of self-protection and the risks of being adversely affected by bank
closures will have to be considered in running a business or in long term
investment.
By minimizing the discrimination against smaller banks by depositors
on grounds of size, such banks are better able to survive. Competition from
79
the smaller banks improves the services at the larger banks and forces them
to achieve greater efficiency.
By offering reliable, basic protection, depositors are relieved of the
need for costly self-protection which may not even be reliable. For instance,
depositors might, despite "having done their homework" and read all the
annual reports of their banks, still fail to find any signs or warnings for
problems that will surface later. Unnecessary bank-runs are yet another form
of costly (and certainly rational given high information costs) self-protection
that depositors cannot be blamed for.
By providing the same protection to the depositors of all banks rather
than providing discretionary protection to individual banks the Government
can avoid allegations of discrimination or unfairness.
By making it less painful to wind up sick and technically bankrupt
banks the Government can avoid being pressured into saving such banks at
great cost to society.
Once we are clear about the functions that a BDI serves we will be in a
better position to work out the best design for such a scheme.
3. OPTIMAL COVERAGE
First, there is little ground for limiting coverage to any specific amount
as proposed in the Consultation Paper and in practice under the U.S. federal
deposit insurance. If protecting businesses is important, such limited
coverage is likely to be grossly inadequate. Proponents of limited coverage
either think of such limits as a way of conserving the DPS fund in the event
a payout is necessary, or believe that larger depositors are less deserving of
protection than smaller depositors. Yet setting a ceiling to protected deposits
is neither an efficient way of conserving the DPS fund nor efficient in terms
of risk management.
Bank deposits, especially demand deposits, are more in the nature of
money than in the nature of an investment. Businesses and households keep
money in the current accounts to settle bills, repay loans, or make advances
to clients. Any disruptions to these transactions will spell trouble for
otherwise sound businesses and their clients. Most of these accounts in Hong
Kong do not earn interest, and there is no question of them being in the "high
risk, high return category" (and therefore unworthy of protection). From the
risk management point of view, there is a prerogative for them to be fully
protected by bank regulators, who should ensure that all the transactions in
the current accounts are not disrupted. In the absence of such protection,
businesses will have to bear the cost of selfprotection even though official
protection by bank regulators is far more economical. Society as a whole
80
will have to bear the consequences should self-protection fail, as chain

effects are bound to occur in the wake of such failures. As demand deposits
are a rather small fraction of all deposits, 100 per cent protection will not
pose a significant drain on the resources of the DPS fund. It yields, however,
very significant social benefits.
A similar, though somewhat weaker argument can be made for
protecting savings deposits. Such deposits are repayable on presentation of
the passbook and at the automatic teller machines. These deposits are
classified as part of M2 in the money supply, but they are about as liquid as
chequable deposits. Characterized by low and uniform returns, they have
little resemblance to risky investments. I recommend 80 per cent protection
for all such deposits. A 20 per cent "haircut" will not excessively
compromise the need to protect a highly liquid form of assets. At the same
time it will more effectively help conserve the BDI fund than providing full
protection up to a cash limit as is currently practised in the United States. It
is well known that depositors are prone to splitting their deposits among
several banks and accounts in order to gain fuller protection under the latter
system. Such a rational response from among the depositors will
unnecessarily increase transactions costs. On the other hand, the "haircut"
approach will avoid the deposit splitting scenario and will also help conserve
the incentive for all depositors to monitor the performance of their banks.
Finally, time deposits and deposits in foreign currency accounts are, in
comparison with demand and savings deposits, much more in the nature of
investment than in the nature of money. 60 per cent protection is
recommended for these deposits. As these deposits comprise the greater part
of banks' deposit base in typical economies, imposing such a limit to
protection serves two important functions. It will help retain "market
discipline" on banks, giving them an incentive to attract deposits on the basis
of sound management of its assets and liabilities. It will also help conserve
the funds of the BDI should a payout be necessary. It is hoped that this
provision will, in addition, remove the objection of the larger banks that
deposit insurance involves cross subsidization at their expense and in favor
of the smaller, weaker banks.
4. FINANCING THE BDI

Those who believe in the user pays principle tend to reject any proposal
to have the government underwrite a BDI. They think that bank depositors,
being the beneficiaries from a BDI, should pay for both the insurance
premiums and the administrative cost of the scheme. There would be no
need for an officially backed credit line for the BDI.
81
On the surface, this seems to make sense and seems to be in the best
interest of taxpayers who are then protected from unknown contingent
liabilities. The logic leading to this conclusion, however, is flawed for two
reasons.
First, provided that the charges are sufficient to cover all costs of the
BDI in the long run, any temporary deficit due to a bank failure occurring
prior to the accumulation of sufficient funds can be recovered over the
longer term. Extending a line of credit to the BDI fund will not cost
taxpayers anything, provided that a market interest rate is charged.
Secondly, if the BDS contributes to a more stable, healthy, and fairer
banking system everyone benefits from it. It is a public good and the
benefits extend beyond the bank depositors. In order for the BDI to yield
the intended benefits, prompt recovery of the protected amount by depositors
in the event of bank failures or suspensions is of utmost importance. In order
to provide for prompt recovery of the protected deposits a sound deposit
protection scheme should have access to financing when needed.
Actually, the limited protection as recommended in this chapter is
unlikely to cost the BDI anything even in the case of a bank failure, because
there are many cushions that help prevent the payouts from eating into the
equity of the BDI fund. First is the equity of the shareholders. Generally,
bank supervisors are expected to take action either to rectify problems found
or to suspend the problem bank long before shareholders' equity has fallen to
zero. Second, the "haircut" of 20 per cent on savings deposits and that of 40
per cent on time and foreign currency deposits mean that even if bank
shareholders' equity has fallen below zero there is a good chance that the
payout will be recovered by the BDI fund as the assets of the bank are
liquidated. Moreover, new legislation can be passed to give holders of
demand deposits priority over other creditors in their claims on the assets of
a failed bank.
There has been considerable debate over whether the insurance
premiums should vary among banks. The principle that insurance premiums
should rise with risks is of course generally accepted. However, many people
argue that varying the premiums charged according to risk is infeasible in
the case of bank deposit insurance, because a bank whose insurance
premiums are raised will be regarded as unsafe. Market reaction may
aggravate the problems of the bank (OECD, 1987). Some people also think
that as a result of direct supervisory regulation the risks of banks may have
become similar. There will then be no need to vary premiums among banks.
Actually, risk-related premiums are not only feasible, but also highly
desirable (White, 1991). The way to go about implementing risk-related
premiums, however, has to be adapted to the unique characteristics of the
banking industry. The specific proposal is that while uniform premiums
82
are charged on similar deposits held in different banks, additional charges

will be imposed on those banks whose risk-adjusted net worth has fallen
below some threshold level. Thus, depositors will not be alerted of any
change in total premiums charged. Potential trouble banks are given the
grace of conducting their businesses as usual while having to pay for their
excessive risk-taking. To make things simple, a surcharge of 50 per cent on
total premiums paid may be imposed on the potential problem banks.
Aware of the potential need to make such payments, banks will become
more careful.
Risk-related BDI premiums have preventive and not
remedial purposes.
In line with the recommendation to cover different kinds of deposits at
different percentages, it is proposed that depositors be charged at 100 per
cent, 80 per cent, and 60 per cent of the standard premium rate for demand,
savings, and other deposits respectively. The base for calculating the
premiums to be paid should be the highest daily balance maintained on each
account.
A case can be made that part of the cost of a BDI be financed from the
general revenue. As argued above, a BDI improves the investment climate of
a country and enhances the stability of the economy. Bank deposit
insurance can also be justified on efficiency and equity grounds (Ho, 1991),
both of which is valued by society at large. The establishment of a BDI will
generate benefits external to the banking industry and depositors during
better times as a result of improved investment climate. The benefits will be
even greater during crises as a BDI saves healthy but otherwise ruined
enterprises. Some depositors may like to have complete protection on all of
their deposits. It is highly desirable that the Government encourages and
facilitates the development of a private market in deposit insurance that
offers additional coverage at commercial rates. There is no need to subsidize
this market, because subsidies for the additional coverage are likely to blunt
market sensitivity and amplify the moral hazard problem.
5. THE RIGHT PERSPECTIVE ON THE MORAL

HAZARD PROBLEM
The moral hazard problem is common to all insurance schemes and it is
real. Yet we must not exaggerate the problem. Rather, we should understand
its nature and take the necessary measures to contain it. As Jao (1982)
maintained, the existence of moral hazard problems does not in itself negate
the value of insurance. The moral hazard problem generally refers to insured
people reducing their effort in self-protection because insurance reduces the
83
benefits of self-protection. In the case of deposit insurance it means that

depositors will have less need to find out if their banks are safe. Unsound
banks are then able to retain their clients and even to attract deposits by
offering higher interest rates. The Savings and Loans (S&L) crisis in the
United States has been partly attributed to the emergence of "zombie" S&L
institutions, namely "living dead" thrift institutions that sucked deposits
away from their competitors and bid down loan rates on high-risk projects,
thereby sapping the strength of these competitors (Kane, 1989, P. 36-37).
This was possible partly as a result of the practice of "capital forbearance" or
leniency on the part of regulators, and partly as a result of the 100 per cent
deposit protection effectively available to most depositors.
Yet while it is one thing to say that the moral hazard problem is real, it
is quite another thing to say that deposit insurance will cause serious moral
hazard problems. Kane (1989) and Davis (1990) have argued that the US
problem was very much a result of regulators' procrastination. According to
Kane, the Federal Savings and Loans Insurance Corporation's "single
greatest mistake" was "to adopt irregular and misleading regulatory
accounting principles that served to create important new opportunities
through which insolvent and unprofitable thrifts could legally conceal their
ongoing weakness." In particular, "The FSLIC's decisions in 1982 to lower
capital requirements and to loosen its definition of what constitutes capital
for regulatory purposes put many economically insolvent clients beyond the
pale of close supervision." (P. 34) Republican Representative Jim Leach, a
House Banking Committee member, who had warned in vain about the S&L
problem for years, concluded: "It's the single greatest regulatory lapse of this
century. It's the single greatest indicator of the defer-at-all-costs approach to
government in this century. " (Newsweek, May 21, 1990, P 23)
The S&L crisis in the United States was also very much a matter of the
"looting" of depositors' and eventually of taxpayers' money by the major
owner or owners of the institutions. Davis (1990) documented many cases of
such looting. One practice, for instance, invo 1ved the trading of a piece of
property at ever escalating prices, with the thrift owner or owners pocketing
lucrative fees for "negotiating" fake deals each time the property allegedly
changed bad-debt loans to one's close associates. Thus, "to deftly rob a
thrift. .. required only a fountain pen, a circle of close personal friends in the
real estate and financial businesses, and the perfect freedom provided by the
absence of regulation." (P 56) If the report of a journalist is no proof, an FBI
investigator's conclusion perhaps should be more convincing. Sessions (1990)
wrote: 2 "insider abuse is a major factor in almost all investigations involving
failed financial institutions." The reason why failures of deposit taking
institutions rise during economic downturns is that "Even though fraud is
84
often a contributing factor in bank failure, it was an economic downturn that

surfaced the fraud." (p.58)
The United States' S&L crisis, then, is more the result of a lapse in
regulatory effort, partly attributable to the budget squeeze,3 and partly
attributable to the lack of political will. It was certainly not the necessary
result of deposit insurance. Indeed, for over fifty years since the
establishment of federal deposit insurance, few banks failed; the 1112 of one
per cent premium which had prevailed since the 1930s was found to be more
than adequate to service the deposit insurance in the United States for
decades. Annual rebates to insured institutions had been made since 1962
through the early 1980's. Premiums were reduced and as recently as 1983
and 1984 stood at 1114 of one per cent and 1113 of one per cent respectively
(Cooper and Fraser, 1986, P 156).
Bank deposit insurance is now common in many industrial and
developing countries. The history of BDI is mainly a happy one. Only in
the United States and only in the 1980s did we find such a mess in the
banking and S&L industries. Notwithstanding the moral hazard problem,
deposit insurance does not in itself imply financial disaster. Only when it is
in the form of full coverage of deposits and combined with lax regulation
will it lead to serious problems.
The kind of fractional deposit insurance for all depositors as proposed
earlier, plus additional, punitive charges on risky banks, will go a long way
towards minimizing the moral hazard problem. Although we have
recommended full protection of demand deposits, this should not be a
serious problem as virtually all depositors who open a current account will
have other accounts and indeed will keep most of their deposits in these
other accounts. Exposure to some risk will make them vigilant, or at least
will give banks an incentive to foster an image of prudent management of
their balance sheets.
6. THE OPTIMAL DEGREE OF OFFICIAL DEPOSIT

PROTECTION
The argument for fractional deposit protection has been made on
grounds of coinsurance for the minimization of the moral hazard problem.
But it can also be made on the grounds of optimization. In Figure 1, MC
represents the marginal social cost of self-protection. 4 It includes the cost
of monitoring one's banks, the costs arising from the diversification of
deposits and assets rendered necessary because of a lack of official
protection, and the costs arising from higher risks of self-protection. MB
85
represents the marginal social benefit of self protection. It includes the

benefit of improved market discipline on the behaviour of banks, reduction
in otherwise-needed regulation that may distort bankers' behaviour, etc.
Optimal self-protection occurs where Me cuts MB. Optimal official
protection is of course one minus the optimal self-protection percentage. A
100 per cent self-protection is justified only if the intersection point occurs
to the right of the 100 per cent self-protection point. While the precise
optimal self-protection percentage must be determined empirically there is
good reason to believe that optimal self-protection is lowest for demand
deposits and highest for time deposits, as the costs arising from higher risks
of selfprotection are certainly highest for demand deposits and lowest for
time deposits. The proposed protection at 100 per cent, 80 per cent, and 60
per cent for demand, savings, and other deposits seems quite reasonable.
Figure 1.
Marginal Cost
M'lroin'l1 RpnPTtt
Percentage of self protection
86
7. CONCLUSIONS
To conclude, a deposit protection scheme serves important functions in
a modern society. Quite apart from protecting the interests of small
depositors who cannot fend for themselves, it improves the business
environment for firms, making them less susceptible to bankruptcy on
account of other people's mistakes. It also makes the banking industry more
competitive. Depositors of large banks today may congratulate themselves
for enjoying good service and security of their deposits. But the good service
of the large banks may be a result of competition from smaller banks which
in the past could thrive because depositors had the impression that the
Government would take over any failed bank. In the wake of the Bee
incident we have observed a fairly significant shift of deposits from smaller
banks to the larger banks. If the Bee shock ends up reducing competition in
the banking industry the larger banks will become complacent or even
arrogant with depositors. All depositors will then end up suffering a decline
in the quality of service and even higher banking charges. A well-designed
deposit protection scheme will protect an otherwise well developed economy
from this unhappy eventuality.
NOTES
I
2
3
4
See "Symposium on Deposit Insurance," Hong Kong Economic Papers, No. 21, 1991.
Sessions was Director of the Federal Bureau of investigation Testimony Before the
House Committee on Banking, Finance, and Urban Affairs.
Davis (1990) reported that in 1983 a starting thrift examiner was paid $14000 a year,
turnover was immense, and there were fewer than 800 of them to cover the entire
country (P 62). badly needed S&L examiners (P 22).
Deposits not covered by official protection are by definition under self protection.
Chapter 8
TOWARDS AN OPTIMAL PUBLIC PENSION
SCHEME
Use the Insurance Principle to protect against longevity risks. Treat

each cohort independently and adopt the Fully Funded Pension Principle for
each cohort. Build in any redistributive elements explicitly and collectively
as desired.
1. INTRODUCTION
Economists around the world are by now quite familiar with the pitfalls of
a pay-as-you-go pension system. An aging society coupled with the prospect
of increasing longevity is causing financial strains in public pension schemes
from Europe to America. l (See Table 1) Calls for pension reform are heard
everywhere. In the industrial world quite a few authors are talking about
privatization of public pensions (Roberts, 1995; Dornbusch, 1995). A favorite
model of pension reform is privatization Chile style. 2 This is an option
(dubbed "personal security" in contrast to social security) considered in the
recent report of President Clinton's Advisory Council on Social Security
(Businessweek, Jan. 20, 1997, 26-27). Yet the superiority of this model is not
unquestioned. Note, for example, MIT economist Peter Diamond's conclusion
in 1993:
We have come to think of privatization as a route to greater
efficiency and lower costs. Thus, perhaps the most surprising
aspect of the Chilean reform is the high cost of running a privatized
social security system, higher than the "inefficient" system that it
replaced. (NBER Working Paper, no. 4510, 1993)
It has been pointed out that the administration costs of public pension
plans are likely to be under-reported (James and Palacios, 1995). However,
under-reporting is unlikely to account for the huge gap between the
administration costs of public and private plans (Mitchell and Zeldes, 1996,
88
p.ll). The U.S. Social Security Administration reported administration costs

at less than 1 per cent of annual benefits while those of the life insurance
industry are known to range from 12 to 14 per cent of annual benefits
(Diamond, 1993, p.7). Economies of scale of management, economies of
supervision, as well as economies arising from the dispensing of much of
marketing costs, are likely to provide important cost savings attributable to the
central administration of public pensions. 3
Equally important, a "private social security system" is a contradiction in
terms. Under such a system, each worker has his own account. Each worker
and his employer are to contribute a percentage of the monthly salary into this
account, and the funds accumulated are managed privately and the total amount
inclusive of investment returns is repayable upon retirement. The only aspect
that is "social" about a purely private system - the Chile model not being a
true example because the government does guarantee a minimum pension and
because it mandates a minimum requirement of annuitization - is that it is
mandatory. A true Mandatory Private Provident Fund (MPPF) scheme - one
that allows individual account holders to opt for lump-sum payment or to buy
an annuity in the market place from voluntary underwriters, such as recently
introduced in Hong Kong (Hewitt Associates LLC and GML Consulting Ltd.,
1995, para. 33) - either fails to pool longevity risks (Eckstein, Eichenbaum,
and Peled, 1985), or fails to deal with the high cost of voluntarily purchased
annuity plans (Abel, 1986). It is also doubtful that workers stand to gain from
employers' contributions. In a highly competitive world how much can be
spent in compensation for labor is dictated by the market. Workers' pay
and/or other benefit are likely to fall, thus offsetting employers' contributions.
The set-up will not expand the real opportunity set open to workers.
On the contrary, employees see their opportunity set reduced because
they are required to contribute the stipulated percentage of their salaries
towards their retirement plans. 4 From this perspective, if the plan has any
merit at all, the merit must be founded on the assumption that citizens do not
know what is best for themselves (the assumption of myopia) or the assumption
of moral hazard, namely that some citizens overconsume before their
retirement, intending to take a free ride on public money to bail them out after
they have retired. As we will see, even if the myopia and the moral hazard
assumptions are valid, the MPPF is not necessarily the best option.
Abel (1986) has demonstrated the welfare enhancing property of "Fully
Funded Social Security." With compulsory participation, fully funded social
security overcomes the problem of "adverse selection." Adverse selection is
the phenomenon of private, voluntary, insurance plans attracting "bad risks."
Compulsory participation, through diluting the risks to the average level of
those of the population, allows the rate of return to become higher than that on
89
private voluntary annuities. With a higher, the actuarially fair rate of return
based on population average mortality, and assuming exogenously given factor
prices, both the steady state consumption of young consumers and the steady
state level of bequests can be shown to be higher than would be the case under
private, voluntary annuities.
Abel has, unfortunately, not addressed the problem of actual design for
such a "Fully Funded Social Security." The fact is that practically all the
public pension plans that we know today are either pay-as-you-go or partially
funded. This chapter will explain how a "fully funded social security" system
can be designed. It will be clear that the design is consistent with the spirit of
the "generational accounting" framework as advocated by Auerbach, Gokhale,
and Kotlikoff (1994).4 Section 2 will present the salient features of the new
model.
Section 3 will provide an analytical investigation of the
microeconomic and political economy properties of the model. Section 4 will
conclude with a discussion of the longer term macroeconomic implications of a
universal fully funded pension system. Finally, Section 5 will provide some
brief concluding comments.
2. THE FULLY FUNDED PENSION FUND SYSTEM

Given the demographic trends of the world's population, economists
generally agree that a pay-as-you-go type of pension system will ultimately
require a rise in contribution rates, a cut in benefits, a postponement of the
retirement age, or a combination of these. To avoid the predicaments of
uncertain benefits or uncertain contributions a fully funded system, like that
practised in Singapore or Malaysia (the "Central Provident Fund" model,
Asher,1994), or a "Mandatory Private Provident Fund" model, seems
necessary.
The spirit of a fully funded system is that workers should save for their
own retirement needs. Post-retirement payouts should be "fully funded" by
accumulated contributions rather than from the general tax revenue.
According to Auerbach et.al. and citing from the Office of Management of the
Budget, "even assuming a discount rate of just 3 per cent and a productivity
growth rate of 1.25 per cent, future generations will still have to pay 65 per cent
more (taxes) than current newborns." (op.cit. p.82) This presents a case of
gross generational imbalance in U.S. fiscal policy, a problem underscored by
generational accounting. 5 In general, only a fully funded system is compatible
with the avoidance of arbitrary intergeneration transfers. However, a fully
funded system does not require that each individual fully fund his own
retirement needs. It is conceivable and desirable that each generation or
cohort, rather than individuals, fund its own retirement needs.
90
The Universal Fully Funded Pension (UFFP) system proposed herein

would have members of each age cohort contribute to and draw from the same
pension fund. Rather than relying on the working population to support the
retirees, each cohort finances its own retirement. The basic version of the
scheme--with refinements to be introduced later--requires each member to
contribute the same amount in each month during the contributing years and to
draw the same amount each month during the payout years. The budget
constraint is one simple equation which says that funds accumulated prior to
the stipulated age for drawing benefits must equal the present value of postretirement payout at the stipulated retirement age:
Nl
~
t=O
C(l + rY =
B/(l+rY
j=l
Here N is the number of contribution instalments in months. C is the

monthly contribution. r is the effective average monthly real rate of return
assumed, and is also used as the discount rate for the n instalments of payouts
at B per month. Life expectancy is equal to the current age plus (N + n ) 112.
Because there is little uncertainty over the life expectancy for a specified
age cohort we can readily calculate the size of the required contribution to
support a specified payout from the stipulated age through the end of the
expected life for the entire cohort, given the long term real rate of return. If
the expected life has increased at the stipulated payout age, say because of a
breakthrough in medical knowledge, the budget constraint requires either that
the payout age be postponed, or the payout be reduced. Each cohort being
responsible for itself, it will have to make the choice. In principle, however,
the payout should be large enough to cover a basic standard of living agreeable
to the community. Individuals have, of course, the choice to top it up as they
see fit from private savings.
The standard contribution, in general, may be borne by the employee or
shared between the employer and the employee. Over the long run assuming
that the market functions efficiently the split between employer and employee
will not make any difference. A self-employed person, a housewife, and the
unemployed has to be responsible for their own contributions unless he/she
satisfies certain criteria for public subsidization, in which case the contribution
is either in part or in entirety wholly paid by the government. The scheme
also allows the government to subsidize an employee's contributions on
grounds of lack of means. This set-up has the advantage of making otherwise
implicit and unclear redistributive initiatives transparent. With a standard
contribution and a standard payout, and providing a means-tested subsidy for
contributions, the design will reduce the regressivity of existing pay-as-you-go
91
plans arising from the longer lives of the high-income people and their steeper
earnings profiles (James, 1995, p.6). It should be noted, however, that
redistribution is not a central feature or an integral part of the scheme.
The UFFP needs to be phased in slowly. Clearly, for cohorts which
have now reached, say, the age of 50, they have only 15 years to pay before
reaching 65 (assumed to be the payout age). Accumulated funds by 65 would
be small. The budget constraint would dictate that this cohort draw a smaller
pension than cohorts that are younger when the scheme starts operation. In
principle we can assume that the older people have accumulated more savings
than the younger ones at the time the scheme takes effect. In addition, during
the phase-in the government will have to provide assistance to the needy aged.
3. MICROECONOMIC/POLITICAL ECONOMY
PROPERTIES OF THE UNIVERSAL FULLY FUNDED
PENSION SCHEME (UFFP)
First, the UFFP is a universal, mandatory plan. It is therefore free from
the problem of adverse selection that would characterize a true MPPF with
voluntary annuity plans. The UFFP covers everybody, including employees,
the self-employed, employers, housewives, and the unemployed. Everyone
within the age group has to contribute unless a means test shows one eligible
for financial assistance.
Second, the UFFP can easily accommodate any degree of redistribution
desired, explicitly and without compromising the fully funded nature of the
scheme. Any subsidy to contribution made to the poor is an explicit transfer
that funds future payouts.
An interesting question is whether government contribution on behalf of
the poor would invite a free-rider problem, as people attempt to declare an
income below the threshold contribution level. Clearly, a system of policing
to ensure that the subsidized do meet the requisite criteria, combined with
necessary penalties to ward off fraud will have to be in place. It may be noted
that the monitoring problem is not unique to UFFP and is part and parcel of any
redistributive program.
Moral hazard is actually likely to be less serious under UFFP than under a
MPPF that exempts the poor young from payment and makes transfers to the poor
old. If transfers are made to the poor old through a means-testing mechanism the
availability of the safety net for those without adequate savings will lure people to
stay poor and avoid contributions. In contrast, under the UFFP young people
with a temporariy decline in incomes are subject a means test that looks at their
net worth. They will need to make contributions if they have sufficient savings.
92
Under the proposed UFFP all individuals are entitled to the pension for
their cohort. Recent immigrants will collect benefits in proportion to the
number of years of their contribution--regardless of whether their contributions
have been subsidized. A recent immigrant starting to contribute, say, at the age
of 50 will be entitled to (65-50)/(65-20) of the standard stipend when he
reaches the age of retirement, which is assumed to be 65.
Third, the stipulated contribution is a flat amount, which makes it simple
to administer. This contrasts with most public pension schemes in practice.
Most public pension plans provide for benefits that rise with contributions and
incomes. Such plans may have distributionally undesirable consequences
because they accentuate the regressivity of many public pension plans earlier
noted. In any case the direction of the implicit redistribution--progressive or
regressive--cannot be easily discerned. In the case of the mandatory private
provident fund contributions are income-related and are akin to a payroll tax.
To the extent that low income people have to struggle to survive, MPPF that
does not provide for public subsidization of contributions and does not exempt
the poor from contributions may push the poor people to earlier death. If
mandatory "private" provident fund schemes are modified to provide for public
subsidization of contributions the schemes would lose their "private" character
and resemble the UFFP.
Fourth, the benefit is also a flat amount, with the full amount payable on
reaching the stipulated age but discounted if early withdrawal of benefits is
deemed necessary because of health reasons. Its magnitude, clearly, depends on
the size of the contributions and the rate of return to investment, just as illustrated
in the equation described earlier.
In principle, the amount should pass a test of
adequacy but should be a basic amount. Individuals would be free to top it up as
they please but would not be compelled into excessive provisions for retirement.
Unlike the laissez faire regime or the pure MPPF, the Universal Fully
Funded Pension pools longevity risks and minimizes cost. Upon reaching the
stipulated age members of the UFFP draw a monthly stipend as long as they
live. The MPPF can, of course, be amended to require the non-discriminatory
treatment of buyers of annuities. This will make it look like a UFFP.
As a fully-funded scheme, the UFFP, like the MPPF, is free from the risks
associated with changes in the dependency ratio, and from the political risks of
participants trying to extract a larger payout, which may affect the Old Age
Pension Plan especially if the govemment is made an automatic contributor, along
with the employer and the employee under the "Three-pronged Contribution
Approach" as recommended by the Hong Kong Social Security Association.
Any plan with the ultimate bearer of the financial burden hidden away is subject to
the risk caused by the "free lunch" mentality. Under UFFP, the requirement that
each age cohort obeys its own budget constraint eliminates the risk that members
of a cohort may attempt to extract larger payouts at the expense of other cohorts.
93
Similarly, by setting up individual accounts and making the benefit-drawer

responsible for his own contributions, the MPPF enjoys freedom from political
pressures. Professor Diamond finds this a key attraction of the Chilean system:
There is real appeal in individual accounts as insulation of the
pension system from political actions to increase benefits without
direct financing. (ibid., p.19)
This advantage of the Chilean system, however, will diminish as the
distribution of income in society gets more unequal. The more unequal is the
distribution of income, the greater pressure there will be for the government to
exempt low income employees from the plan, and for the government to provide
assistance for the poor old whose accumulated savings may be inadequate. In
Hong Kong under the mandatory provident fund introduced in 2000,
employees with monthly income below HK$4000 are exempted. There will
be political pressure on the government to raise this exemption level and on the
government to support the poor old. The problem of moral hazard and
politicization cannot be dismissed. Thus, the inability of the MPPF to provide
universal, basic support for the elderly means that there will be demand for an
extra tax-financed pillar for the needy. Such a pillar, unfortunately, may lure
households into earning below the exemption level of income.
4. LONG TERM IMPLICATIONS FOR SOCIAL

SECURITY AND FOR THE MACROECONOMY
Given the budget constraint listed above (p. 90), to the extent that the
realized rate of return turns out deviating from the expected rate, actual payouts
may deviate from expected payouts. However, while the realized rate of return
may fall short of the expected rate for some cohorts it may exceed the expected
rate for some other cohorts. While no one can insure such systematic deviations
from the expected rate of return for an entire cohort momentarily, the government
has a long time horizon and is in the position to offer, upon payment of the
necessary premiums, a guarantee for some minimum real rate of return for funds
invested by a cohort that desires to contain investment risks, by using surpluses for
one cohort to tide over deficits for another cohort. This approach to deal with
"correlated risks" will achieve Pareto gains for all generations which are exposed
to such risks, which lack commercial insurers to protect them from such risks, and
which are risk averse. 6
Compared to a provident fund scheme which is in essence simply a form of
forced savings, the Universal Fully Funded Pension is likely to result in smaller
94
savings. This is by virtue of the fact that our capital markets are incomplete and
imperfect. If our capital markets were complete and perfect the very idea of
forced savings would be inconceivable, because those who prefer to save less can
always borrow on the security of his future claims on his personal "forced"
savings. In general, in view of longevity risks if the provident fund mode of old
age security is adopted more savings will have to be made individually than are
necessary to cover the expected life span. Although this means that investment is
likely to be lower under the UFFP scheme than under the provident fund scheme
we must not assume that more investment is necessarily desirable, as the benefit of
higher current consumption should also be considered.
Because a provident fund scheme alone cannot guarantee a minimum
standard of living for the elderly many of those who subscribe to a mandatory
private provident fund scheme also believe that there should be a "mandatory
publicly managed pillar" as well (James, 1995V The coexistence of a heavily
regulated MPPF with a public pension scheme is, however, administratively
demanding. Moreover, the larger this tax-financed pillar is, the greater will be
the distortionary effects associated with the related tax burden. Admittedly, the
tax-financed subsidies for contribution by the poor under the UFFP are also
distortionary. As always we have to find a balance between redistribution and
allocative efficiency. Table 2 presents a comparison of the properties of the
MPPF and the UFFP.
5. CONCLUSIONS
According to James and Vittas (1994) the most general recommendation
and one that is relatively clear-cut and non-controversial is that old age security
should be based on a multi-pillar system that comprises:
broad based privately managed mandatory savings-annuity pillar to avert

the results of myopia and incomplete insurance markets
a carefully designed public pillar for redistribution to those in long term
poverty, and possibly for insuring against correlated risks,
tax-advantaged private pensions, and
a purely voluntary savings pillar.
A multi-pillar system appears to be both logical and indeed the direction of

reform being considered in Europe, America, and elsewhere (Ploug and Kvist,
1996; Businessweek, January 20, 1997). Two major questions remain, however.
One is whether the private component of old age security should be mandatory or
voluntary. The other is if there is still a role for public pension, how should it be
reformed to be fmancially viable. Our analysis suggests that the mandatory
95
private option to replace the public pension system is fraught with many problems,
which would require a heavy dose of regulation to avoid. The pay-as-you-go
public pension system, however, is subject to uncertainty and financial risks. On
the other hand, a mandatory public pension system will deal with longevity risk
far better than individual savings accounts or provident funds.
The fully funded pension system as proposed provides a mandatory pension
that deals with myopia and incomplete insurance markets and offers government
subsidization of contributions for the poor. It therefore accomplishes by and large
the objectives to be achieved by the first two pillars as envisaged by James. The
fully funded pension system is by design small scale allowing for "top-up" by
individuals as they see fit. This recognizes the imperfection and incompleteness
of capital markets, which make it difficult for individuals to transform excessively
large future pensions into current consumption.
A recent article in a recent edition of World Bank Development Brief
(August 1995) aptly remarks that "The future course of mortality is a major social
risk that must be borne by some group no matter how retirement incomes are
organized." The UFFP system discussed is predicated on the assumption that
each cohort should be responsible for itself, so that no generation is burdened with
the uncertainty of supporting another when mortality and demographics change.
This is consistent with a concept of justice linked to Rawls (1972) as discussed in
Chapter 3. If we all faced a "veil of ignorance" and were randomly assigned to
different cohorts, we would probably have preferred a system like what was
suggested, namely that each cohort saved for its own retirement.
Many countries have different pensions plans for different occupations,
and some countries have different pension plans for employees and the selfemployed (International Social Security Association, 1987; Noguchi, 1983).
The proposed UFFP is based on the assumption that a mandatory plan should
be universal, simple, and basic, and free from the vagaries of uncertain
demographics, without inhibiting each occupation and each company from
developing its own private schemes.
Table 1. Public Pension Expenditure as a Percentage ofGDP in OECD Countries
Country
1960
1975
1980
Austria
9.6
12.5
13.5
Canada
2.8
3.7
4.4
France
6.0
10.1
11.5
Germany
9.7
12.6
12.1
Italy
12.0
5.5
10.4
Japan
4.4
1.3
2.6
Sweden
4.4
10.9
7.7
U.K.
4.0
6.0
6.3
U.S.A
4.1
6.9
6.7
Source: Table 1 in Mitchell (1993).
1985
14.5
5.4
12.7
11.8
15.6
5.3
11.2
6.7
7.2
96
Table 2. Comparison of Mandatory Provident Funds System and the Fully Funded Pension System
Criteria
Financial Stability
Administration
Insurance Benefits
Freedom from
Political Risk
Distortion of
Individual Choice
and Sacrifice of
Individual Freedom
Mandatory Private Provident Fund

System*
Independent of changes in the
dependency ratio
Privately administered but publicly
supervised; supervision potentially
difficult if schemes are too
numerous.
Either no insurance benefits and no

risk pooling or high insurance cost
because of adverse selection
problems.
Contributors will have no incentive
to boost scale of scheme on account
of others shouldering the cost. But
there will be pressure to provide for
a tax-funded pillar for redistributive
purposes.
Greater choice for investment
outlets. Distortion to the
savings/consumption decision can be
serious if scale is large.
Public Confidence
An individual fund could be subject

to large investment risks. Public
confidence generally higher
compared to Pay-as-you-go schemes
under adverse demographic trends.
Redistribution
Requires a separate "pillar"
Coverage
Adequacy
Limited to employed people

Adequacy depends on total
contributions of an individual. As a
defined contribution plan it does not
guarantee post-retirement incomes.
Portability
Portable with transaction costs for

plans that are employer-specific;
question of portability does not arise
for plans that have been chosen by
employees
Universal Fully Funded

Pension
Independent of changes in
the dependency ratio
Centrally administered under
a Board of Trustees for each
cohort; funds can be "farmed
out" to private fund
managers.
Insurance benefits because
there is risk pooling for
people with unknown
lifespan.
Same. There will be
pressure to provide for
redistributive subsidies.
No individualized choice for

investment for contributed
funds. UFFP is small in
scale to avoid distorting the
savings-consumption
decision.
Risk spreading for funds
contributed by the entire
cohort, and appointment of a
Board of Trustees by
members contribute to
higher confidence
Redistributive provisions are
explicit in the subsidies to
contributions. The degree
of redistribution a matter of
public choice.
Universal
Any level of payout can be
set so as to meet socially
determined adequacy
standards; larger payout
would however entail larger
distortions to choice.
Question does not arise as
there is just one central plan
for each cohort.
97
* MPPF referred herein is a pure form of private provident fund that does not allow public
contribution or provide for public guarantee of any sort. Allowing for public contribution on
behalf of participants or providing public guarantee of a minimum pension blurs the distinction
between MPPF and UFFP. A referee points out that some countries, such as Latvia, operate a
version ofMPPF that provides for government contribution on behalf of the unemployed, mothers,
and students at the minimum wage.
NOTES
4
5
Prof. Robert Fogel in his 1993 Nobel lecture presented evidence that the mortality and
disability rates for the elderly had fallen for longer than expected, with the result that
the U.S. elderly population in 2050 was likely to be underestimated by the Census
Bureaau to the tune of 36 million. Recent breakthrough in genome research is
causing both excitement and anxiety because of unpredictable implications on
longevity.
Actually the Chilean system is more properly represented as based on "an intermediate
form of funding." The Chilean government guarantees a minimum benefit payable
irrespective of the performance of the funds invested. (Mitchell, 1993, pp.27-28)
Another well-known system, the Central Provident Fund (CPF), which is in operation
in Malaysia and Singapore, is privately and fully funded but are publicly administered.
See Asher (1994).
Central administration does not necessarily mean government management of the pension
funds. It does mean, however, that there may be a monopsony (sole buyer) for fund
management services. A board of trustees charged with administration of a public
pension may "farm out" funds for management by private pension funds. Under such a
setting the private pension funds would be in a weaker position to pass along marketing
costs to consumers
If the capital market were perfect individuals could trade future payouts for current
income. But if this were the case the very concept of mandatory provident fund
would fall apart as no individual could be forced to save more than he would like.
Robert Haveman (1994) has raised some questions about the generational accounting
framework, but conceded that it should serve "as a useful supplement to the annual
budget." (p.ll0) The Office of the Management of the Budget (OMB) presented for the
first time in history a tabulation of the lifetime tax rates of current and future generations in
the FY 1994 budget.
Prof. Yew-kwang Ng pointed out that if we all face a Rawlsian "veil of ignorance," we
may prefer some cross-subsidies between different cohorts to reduce uncertainty and
increase expected utility. In the same spirit Ho (1981) introduced the concept of
Pareto risk improvement and suggested that an arrangement that led to an ex post
redistribution may be Pareto improving if all parties concerned are ex ante risk-averse
and if the arrangement reduces everyone's risk exposure.
In Hong Kong a motion to establish a pay-as-you-go pension along with the mandatory
private provident fund scheme was passed in March 1995 and again in December, 1995.
See Mingpao, 14 December, 1995. It should be noted that motions passed in the
Legislative Council in Hong Kong represent only recommendations that need not be
implemented by the govemment.
Part 3
MACROECONOMIC RISK MANAGEMENT
Mismanagement of the macroeconomic environment has been the

cause of major economic disasters including the Great Depression of the
1930s and the recent Asian Financial Crisis.
Policy makers have
traditionally been too preoccupied with bringing one or two indicators into
line with their prior expectations to come up with the needed policies to
bring about a stable macroeconomic environment which is needed for
businesses to operate efficiently and to grow. Chapter 9 argues that in
countries that adhere to basic rules of fiscal discipline and that allow real
interest rates to stay around the long term rate of return to capital inflation
risks have been successfully contained and often overstated Chapter 10
looks at the risks of interest rate and exchange rate fluctuations. It
demonstrates that the misbehavior of our central banks have directly caused
or aggravated major crises, including the Great Depression of the 1930s, the
global stock market crash of 1987, the rise and fall of the Japanese economy,
and the Asian Financial Crisis in 1997-98. Chapter 11 looks at the
formation of asset price bubbles, and argues that the world needs better
savings instruments that can provide true financial security. The concept of
a real value unit of account is advanced. It is argued that the lack of a
savings instrument of reasonable security drove asset prices in Japan skyhigh in the 1980s. Sharp appreciation of the yen, by discouraging
purchases of Japanese assets and encouraging sales eventually led to the
crumbling of asset prices at home. It also led to a sharp fall in the yen
value of foreign-held assets, creating a gigantic financial crisis. Finally,
Chapter 12 will look at transparency, an important subject in macroeconomic
risk management.
Chapter 9
THE RISKS OF MONETARY CRISES:
INFLATION
Avoid malignant inflation. Abhor not benign inflation. Index debt

instruments to prevent borrowers from getting a free ride from inflation.
Never index to protect people from shortages.
1. INTRODUCTION
At one time, opinion polls indicated that inflation was looked upon as
Public Enemy Number One in the United States. However, for countries
which observe basic rules of fiscal and monetary discipline the dangers of
inflation have been grossly overstated. It is not apparent that relatively high
inflation, even going into the teens, would necessarily damage the economy.
Hong Kong during the late seventies and early 80s routinely saw inflation
going into double-digit levels (Table 1). Yet the economy went through rather
turbulent periods (not of its own making)-with a major oil crisis and serious
global recessions-largely unscathed. I have no intention here of preaching
the virtues of inflation. It is important, however, to note that there are
different kinds of inflation. Inflation can be innocuous and even beneficial,
and inflation can be dangerous and even lethal.
Generally speaking, inflation that is caused by cost-push factors is
relatively innocuous and may be beneficial. Inflation that is caused by an
expanding money supply, on the other hand, can be very dangerous. While
unbridled expansion of the money supply can ruin the market economy,
modern societies that observe the basic rules of fiscal and monetary discipline
should have nothing to worry about "excessive inflation." I shall elaborate on
what I mean by basic rules of fiscal and monetary discipline below.
102
Table 1.
Hong Kong
Year
InflationCPI-A
Economic
Growth
1975
1.2
1976
3.4
1977
5.8
1978
5.9
1979
11.6
1980
15.5
1981
15.4
1982
10.5
1983
9.9
1984
8.2
0.3
16.2
11.7
8.5
11.5
10.1
9.2
2.7
5.7
10.0
United States
1975 1976 1977 1978 1979 1980 1981 1982 1983 1984
Year
Inflation
3.2
4.3
9.1
5.8
6.5
10.3
6.2
7.6 11.3
13.5
CPI-U
Economic
-0.4
2.3
-2.1
4.0
7.0
5.4
4.7
2.8
-0.3
5.4
Growth
Sources: Gross Domestic Product 1961-1999, Hong Kong: Census and Statistics Department;
Bureau of Economic Analysis and Bureau of Labor Statistics, US Government.
2. A HISTORICAL PERSPECTIVE
Before we go into the subject of fighting inflation, a historical perspective
is warranted. We must realize that in all of the history of mankind, every
episode of hyperinflation was a result of one or more parties trying to unload
the burden of shortage onto others in society. Typically, it was started when
the government "borrowed" money from the central bank to cover its
expenditures. Typically, there was political and economic stability and acute
shortages, and prices were rising.
For example, Yugoslavia in the early nineties was in the grasp of a deep
civil war and the government simply could not raise the needed revenue
through normal taxes to meet its escalating expenses. Like many earlier
governments facing similar situations it resorted to the printing press to finance
the war. As a result, it found itself in the grasp of very serious hyperinflation.
The Nationalist government under Chiang Kai-shek during the civil war
with the Communists in China did the same, leading to the hyperinflation
episode of 1946-49.
Although civil war was not the cause the German hyperinflation in the
early 1920s this episode of hyperinflation was also the direct result of resorting
to the printing press when government revenue fell dramatically on account of
social and political turmoil.
Perhaps one of the most intriguing episodes of hyperinflation is that of
Hungary from December 1945 to July 1946. At the outset, the country was
beset with serious shortages and prices had been rising rapidly. The inflation
The Risks ofMonetary Crises: Inflation
103
was a natural reflection of the shortages, and would have diffused the burden of
the serious shortages across the entire population as well as the government.
The government, however, tried to avoid the erosion of the real value of taxes
collected through indexing tax liabilities. The idea was to force taxpayers to
compensate the government for any loss in real purchasing power between the
time the tax bill was sent out and the time of actual payment. In January 1946,
various banks also set up the so-called valorization accounts, which effectively
indexed the values of deposits against inflation. Unfortunately, because the
shortages were real the indexing could not eliminate the shortages. Even as
depositors got back twice as much money as what had been deposited in the
first place on the back of a doubling in the price level, there was no guarantee
that when doubled-up money could buy the same real goods in the following
periods. The price index went up from 100 to 39,623,0C1J,0C1J,0C1J,0C1J,0C1J,0C1J,0C1J,0C1J
within a year.
3. SOLUTIONS OR PROBLEMS?
When there are serious shortages, and output lags behind demand, prices
have to rise. The inflation that arises because ofthe real shortages is Market's
way of spreading and diffusing the burden. Everybody finds inflation
burdensome, but the culprit is really not inflation but shortages. Given the
shortages, which could be quite unavoidable, for example when there is an oil
shortage imposed upon us externally, or when production has been disrupted by
a war, the realistic way to deal with the problem is to bite the bullet. Some
demands have to go unsatisfied. In such times of exigencies, rationing or
inflation would be unavoidable. While rationing could be superior when it
comes to distributing certain essential goods inflation could be the more
efficient and the fairer way of dealing with the problem in most cases. In this
sense, inflation is a "solution" to the shortage problem.
If we refuse to corne to terms with the problem of shortages, and start
turning to the printing press in an attempt to run away or get shelter from the
problem of shortages, inflation becomes a problem. Inflation will take on a
life of its own. Rather than prices rising in response to known shortages,
various parties, armed with their loads of money, try to compete away the
scarce resources from others. This competition becomes a negative sum game
because when inflation takes on a life of its own the market ceases to function
efficiently or at all. Production and division of labor and investment become
ever more difficult.
104
4. BENIGN INFLATION
In contrast, imported inflation and cost-push inflation which are truly
exogenous and do not originate from an increase in the money supply is mostly
benign. As Table 1 shows, Hong Kong had double-digit or nearly doubledigit inflation from 1979-1984, but the economy was spared the fate of two
recessions as had hit the US. Along with the fairly high inflation, the Hong
Kong dollar had depreciated right through October 1983, when it was linked to
the US dollar through a currency board mechanism. But both the short-term
and the long-term performance of the economy had not been jeopardized.
While the inflation seems to adversely affect the livelihood of the people the
true culprit is shortage-which can be artificial such as caused by the oil
embargo under OPEC in the seventies, or natural disasters that result in large
scale destruction of crops. The resulting higher prices effectively ration the
scarce goods among people. Such inflation is in reality benign in character.
Because of certain constraints that include human nature as it is and
institutions as they are, there is some resistance against wage declines and such
resistance varies from sector to sector because of institutional reasons. For
this reason, to expect price declines to exactly offset price increases as relative
scarcity changes, thus keeping inflation at zero, is unrealistic. The efficient
relative price changes are more likely to take place if prices either rise or stay
put. The prices of those goods and services which have become more scarce
relatively will then rise faster. Creeping inflation of this kind is benign.
Since the early 1970s many economists have accepted the concept of
"natural rate of unemployment," believing that an attempt to reduce
unemployment below this natural rate will engender accelerating inflation.
The logic of this theory is that it is in the nature of the labor market to have
some people "in between jobs." In a steady state, when peoples'
expectations about inflation and actual inflation match, the natural rate of
unemployment will result.
An expansionary policy to reduce
unemployment will result in the actual inflation running ahead of inflation
expectation. Superficially attractive job offers will fool job seekers into
accepting jobs sooner than otherwise, leading to a temporary decline in the
rate of unemployment. Since people will not be fooled forever, the result is
accelerating inflation.
Actually there may also be a "natural rate of inflation" which is
"natural" or inherent in human nature and socio-economic institutions. If
we tried to reduce inflation below the natural rate- that which is consistent
with the public's natural resistance against wage declines-we could end up
with rising unemployment. An excessively tight monetary policy aimed at
forcing wage and price declines to offset concurrent wage and price
increases may create unemployment.
Indeed, it is the threat of
The Risks a/Monetary Crises: Inflation
105
unemployment that ultimately intimates workers into accepting reduced

wages.
In a similar spirit that comes to terms with human nature and
particularly workers' imperfect perception of reality, Akerlof, Dickens, and
Perry (2000) suggest that employees' job satisfaction may be higher in
periods of moderate inflation and rising nominal wages. They estimated
that the employment- maximizing rate of inflation ranges from 1.6 per cent
to 3.2 per cent. They categorically rejected zero inflation as a policy target.
5. MONEY GROWTH THE CAUSE OR THE RESULT OF

INFLATION?
Nobel Laureate Milton Friedman taught that inflation is everywhere and
always a monetary phenomenon. Professor Friedman argues that if the money
supply does not accommodate, then all inflation, demand-pull, cost-push, or
otherwise, would grind to a halt.
Prof. Friedman is right. All kinds of inflation can be choked off by
keeping a tight grip on the money supply. However, just as with all other
kinds of public policy, we have to consider the costs versus the benefits.
If there is shortage, prices will rise. Because we cannot expect prices of
goods and services not in shortage to fall by exactly the amount as to neutralize
these prices increases, generally shortages, even those that are not widespread,
will result in a rise in the price level. The increases in the price level will
result in a greater demand for money. In response to such demand, generally
there will be a greater supply of money through the credit expansion process.
The increase in the money supply is under these circumstances a result of the
inflation, not the cause.
Of course, things can run the other way round. There can be excessive
expansion of credit because the cost of borrowing is too low. The increase in
consumption and investment may exceed the capacity of the economy to
produce, and inflation may result. Because inflation renders money repaid
worth less than money borrowed it further increases the attractiveness of
borrowing. Inflation may then accelerate. Here the increase in the money
supply is the cause of inflation. The overheated economy cannot be sustained,
paving the way for a substantial economic downturn. Central banks would be
wise to prevent economies from overheating.
106
6. INFLATION RISK AND MACROECONOMIC

ENVIRONMENT MANAGEMENT
To prevent the economy from overheating does not require cyclical
adjustments of interest rates, as has been practised in the United States and
many other industrial nations. All that is required is to keep the real cost of
borrowing within a relatively narrow range of 2.5 to 3.5 per cent, which
corresponds to the real rate of return to capital that has prevailed for decades.
As long as the real cost of borrowing is transparent to the borrower and kept at
such a level, investors will not borrow to finance investments that can yield
only a lower rate of return, so investment would not be excessive. Similarly,
only consumers willing to pay such interest costs would borrow to finance their
consumption expenditures. Consumption expenditures will also not be
exceSSlve.
In general, central bankers believe that there are the following approaches
to monetary policy:
Money supply growth targeting

Interest rate targeting
Inflation targeting
Output targeting
Currency board
Discretionary fine-tuning
Money supply growth targeting, once a favorite approach advocated by

monetarists, has largely fallen out of favor these days, primarily because the
relationship between velocity of money and economic activity has changed
tremendously with changes in technology and financial market innovations.
Interest rate targeting, once advocated by Keynesians, has never really been
considered seriously by central bankers. With possible changes in inflation
expectations, keeping interest rates stable may not keep real interest rates stable,
and under some circumstances could engender excessive demand and hence
inflation because real interest rates could become negative.
Inflation targeting is practised by the Bank of England. Money is
tightened up or loosened up depending on whether the observed inflation rate
exceeds or falls short of the target rate. This approach is not satisfactory
because inflation changes may be caused by non-monetary factors. As
alleged earlier on, a purely cost-push inflation, from external uncontrollable
sources, is essentially benign and so there may be little need to tighten up the
money supply.
The Risks ofMonetary Crises: Inflation
107
Some central bankers are uncomfortable with economic growth rising

beyond certain levels and go about tightening up the money supply whenever
the GDP grows "excessively." At one time, the Federal Reserve Board was
thought not to tolerate a GDP growth in excess of 2.5 per cent. Such a target
has proven far too conservative, so the Federal Reserve is now known to
tolerate a higher rate of growth. The Fed, however, has never announced any
threshold rate of GDP growth, leading to much market speculation. Because
rapid output change can be a result of productivity improvement, an expansion
in production capacity, a catch-up from a situation with much slack, etc.,
specifying any GDP growth rate as a dividing line between an overheating
economy and one without overheating is subjective and unreliable.
Some economies, including Hong Kong since October 17, 1983, practise
what is known as a currency board system. The currency is linked to a major
international currency, typically the US dollar. Bank notes are issued on
submission of US dollars at the official exchange rate. This system has the
advantage of transparency and being rule-based rather than discretionary.
Central bankers are spared the need to make judgments and will avoid
judgmental errors.
Finally, discretionary fine-tuning refers to the freedom to tighten up or to
loosen up the money supply whenever the economy shows signs of overheating
or excessive cooling. It allows the enlightened central banker to exercise his
wise judgment freely, but then it also allows the unenlightened central banker
to tighten or loosen up monetary policy at the wrong time and thus aggravate
fluctuations.
There is, of course, no perfect answer to the problem of monetary policy.
But investors and consumers all prefer greater stability, other things being
equal. The fact is, so far US monetary policy is seen to be cyclical, with a
series of interest rate drops followed by a series of interest rate increases, and
the swing from trough to peak can be a few hundred basis points. The rest of
the world often follow these interest rate movements faithfully. This leads to
excessively large gyrations in financial markets.
Given the shortcomings of these approaches to monetary policy I would
like to advance the proposal of real interest rate targeting as a practical way of
stabilizing the macroeconomic environment. I should like to point out the
following facts:
While it is true that real interest rates cannot be set and held at any
arbitrary level, real interest rates can be held near the long term real rate
of return to capital. In principle, the real interest rate target should
correspond with the long term real rate of return to capital investment.
108
The existence of indexed bonds that are now traded openly, both in the
US and in the UK, means that real interest rates can be moved in the short
term through open market selling and buying of these bonds.
The financial markets will feel assured if there is the announcement that
monetary policy keeps the real cost of borrowing near the long-term real rate of
return to investment. The financial markets know that such a policy will
stabilize real borrowing costs, prevent the economy from overheating, and is
credible.
7. CONCLUSIONS
When inflation gets out of control the damages to the economy can be
catastrophic. Clearly, the risks of inflation should not be taken lightly.
However, today we have ample safeguards against malignant inflation.
Keeping real rates of interest positive and close to the long-term equilibrium
rate of return to capital will avoid excessive borrowing and hence excessive
private sector spending.
Governments following basic rules of fiscal
discipline by striving to maintain budget balance at full employment will help
avoid excessive public sector spending. If these basic rules are followed, then
there should be no worry about inflation. Indeed any residual inflation should
be benign in nature. Being nervous against such benign inflation is counterproductive.
Just as inflation itself can be malignant or benign, so indexing against
inflation can be harmful or beneficial. Hungary's experience shows that
indexing inappropriately can be very dangerous. Hungary wanted to use
indexing to protect everybody against the consequences of a real shortage. Of
course that would not work. The ongoing inflation was benign and beneficial
because it forced everybody to bear part of the cost of the shortage. Indexing
savings and tax revenues against inflation when there is a real shortage is trying
to achieve the impossible.
Indexing to force borrowers to face up to the real cost of borrowing is an
altogether different animal. Because the cost of borrowing is indexed against
inflation, borrowers are forced to face up to the cost of scarcity and so are
prevented from borrowing too much. The inflation-indexed bond is a big
financial market innovation that can help tame inflation and avoid arbitrary
redistribution between creditors and debtors.
Chapter 10
THE RISKS OF MONETARY CRISES:
CURRENCY CRISES AND INTEREST RATE
GYRATIONS
Maintain real exchange rates and real interest rates at levels

compatible with full employment. Defend full-employment compatible
exchange rates wholeheartedly. Maintain real interest rates at close to the
long term rate of return to investment.
1. INTRODUCTION
Currency crises are serious matters.
They can be extremely
destructive, pushing otherwise well-run enterprises out of business,
eliminating hundreds of thousands of jobs, ruining families and lives. The
Asian Financial Crisis of 1997-98 was particularly devastating. Wealth
valued at hundreds of billions of dollars virtually disappeared overnight.
The damage was certainly more serious than any natural disaster could have
caused.
Many commentators trace currency crises to currency attacks, but for
currency attacks to be successful, one or both of two conditions must exist.
The first is that the values of the currencies in question are out of line with
the economic fundamentals. This is a sufficient condition for currency
attacks to be "successful." Here "success" may mean that the currency in
question is actually devalued, or that domestic prices and domestic asset
prices decline so much that real exchange rate adjustment is achieved
without the nominal exchange rate itself adjusting. The second is that the
central bank makes policy mistakes, has inadequate foreign exchange
reserves, or has inadequate access to credit lines.
If the value of a currency is compatible with full employment and long
term balance of payments equilibrium, we can say that the prevailing
exchange rate is defendable even though there may be a balance of payments
deficit in the short term. The central bank should, then and only then, use
reserves and any available credit lines to defend the currency. Because the
110
economic fundamentals are sound the economy will, in time, generate

sufficient income for the central bank to repay its debt. On the other hand,
if the values of the currencies are out of line with the economic fundamentals,
then the prevailing real exchange rates are not defendable. Either the
nominal exchange rate has to decline or domestic prices have to fall. There
will be little point in trying to defend the currency. That is why, to this day
I still think that George Soros did the UK a great service forcing the pound
sterling to delink from the European Monetary System in 1992. Devaluing
is not the end of the world. The devaluation of the British pound and the
interest rate declines following the devaluation actually jump-started the
economy.l In contrast, in 1997 virtually all the Asian economies hit by
currency attacks tried to prevent further currency devaluation by increasing
sharply domestic interest rates. The very high interest rates destroyed the
economic fundamentals otherwise improved by the initial devaluations.
I have no doubt that the key to maintaining stability in the foreign
exchange markets is to know the values of currencies which are
economically sensible and therefore defendable, and to defend these values
whole-heartedly and with international help if necessary. We must note
that neither the regime of floating exchange rates nor that of fixed exchange
rates can be counted upon to bring about economically sensible and
defendable exchange rates. That is why both a floating exchange rate and a
pegged exchange rate may lead to problems. The appreciation of the yen in
the late 1980s and early 1990s when the yen was floating had caused Japan
serious economic difficulties and is ultimately responsible for the weakness
of the Japanese economy throughout the nineties.
The de facto
overvaluation of many South East Asian currencies prior to the currency
crisis of July 1997 when they were more or less linked with the U.S. dollar
also had invited major currency attacks. The linking of the pound sterling
to the European monetary system prior to 1992 had caused the UK serious
economic difficulties, pushing up its unemployment rate and hurting exports.
Currency attacks can potentially do good things and bad. As I had
maintained earlier on, George Soros did the UK a great service by pushing it
off the European Monetary System. After the pound sterling had de-linked
from the European Monetary System, the Bank of England did not panic.
Instead, it allowed interest rates to decline. This jump started and brought
about a dramatic turnaround of the British economy. Even today, the UK
remains the strongest economy in all of Europe, enjoying a very low
unemployment rate and a very strong fiscal position. On the other hand,
Indonesia and Thailand suffered tremendously in the aftermath of the
currency attacks. Backbreaking interest rates compounded the problems of
already weak economic fundamentals. The economies slipped into major
recessions.
The Risks ofMonetary Crises: Currency Crises and Interest Rate Gyrations
111
2. THE ECONOMIC COST OF HIGH REAL INTEREST

RATES
Just as overvaluation of the currency can derail an economy by
rendering it uncompetitive internationally and choking off external demand,
so high real interest rates can plunge an economy into recession by curbing
domestic demand.
John Maynard Keynes drew the insight from the Great Depression in
the nineteen thirties that maintaining "effective demand" at a level consistent
with full employment or "demand management" is a prime responsibility of
the government. In his General Theory of Employment, Interest, and
Money, he clearly stressed the importance of maintaining interest rates at a
sufficiently low level-if that was possible (pp.205-209). He was aware
that interest rates should not be too low, otherwise "a state of true inflation
will be produced." (p.202) But keeping interest rates low enough to achieve
full employment could be difficult. "For example, in a country linked to an
international gold standard, a rate of interest lower than prevails elsewhere
will be viewed with a justifiable lack of confidence; yet a domestic rate of
interest dragged up to a parity with the highest rate (highest after allowing
for risk) prevailing in any country belonging to the international system may
be much higher than is consistent with domestic full employment." (p.203)
Although the world has given up the gold standard for a long time this
observation of Keynes is still relevant. When there is a lack of confidence
in a currency, interest rates may have to be much higher than what is
compatible with full employment in order to arrest a flight of capital. Yet
backbreaking, high interest rates are unsustainable either.
Conceptually, there are different combinations of interest rates and
exchange rates that are compatible with full employment. But depending
on whether interest rates are higher (and exchange rates are lower) or the
exchange values of the domestic currency are higher (and interest rates are
lower), the mix of domestic demand and external demand in the total
demand will be different. When interest rates go higher and exchange rates
go lower, external demand will fill in where domestic demand falls short of
full employment. On the other hand, when interest rates go lower and
exchange rates go higher, domestic demand will rise to fill what is vacated
by external demand.
If the (real) interest rates are higher than what is necessary to maintain
full employment, investment will shrink and unemployment will rise, unless
the currency is devalued. If the latter should take place and in the right
magnitude, external demand would rise and restore aggregate demand to the
level needed for full employment. Starting from a point where the level of
112
aggregate demand is at the right level for full employment, if a capital flight
should cause pressures to devalue and the central bank raises interest rates to
defend the currency, aggregate demand would shrink, and the economy will
slip into recession. 2 Since a recession will weaken confidence further, a
vicious circle would develop.
There would be new pressures for
devaluation, and new pressures to raise interest rates. Eventually the
economy would collapse. Apparently this was what happened with
Indonesia and Thailand during the Asian Financial Crisis.
We have now accumulated a fair bit of knowledge about how high real
interest rates and currency over-valuations do to the economy. Experiences
in the United States, Canada, Australia, the United Kingdom, and Japan all
tell the same story. Excessively strong currencies combined with high real
interest rates always lead to recessions. Deep recessions mean joblessness
for many and big fiscal deficits for governments. Investment and economic
growth will slow down, implying long-term losses in productivity and
welfare.
The surge in the fiscal deficit in the United States from 1981 to 1983,
with the federal deficit surging from 2.6 per cent to 6.3 per cent of the GNP,
was a direct result of the tight money policy of 1979-81. Following a
similar tight money period from 1980-82, Australia saw its fiscal deficit
surging from 0.34 per cent of the GDP to 3.7 per cent by 1984. In Canada,
the fiscal deficit also rose sharply during 1981-84, thanks to a monetary
policy that mirrored the tight money of Paul Volcker in the U.S. More
recently, the recession of 1990-91 was a direct result of a policy of high
interest rates and strong Canadian dollar through 1990/91. Tight money
pushed Canada's unemployment rate above 11 per cent in 1992 and 1993
and the federal deficit above 6 per cent of the GDP. Only after monetary
policy eased in the nineties did the Canadian economy bounce back to life
and the budget deficit fall sharply. In the United Kingdom, prior to the delinking with the European Monetary System in 1992 British interest rates
were very high and the currency was overvalued relative to what was
compatible with full employment. As a result both the fiscal deficit and the
unemployment rate were very high. In 1992, George Soros successfully
pushed the British pound off the European Monetary System. While the
unemployment rate and the fiscal deficit, well known to be a "lagging
indicator" continued to rise briefly and peaked in 1993, at lOA per cent and
7.3 per cent of the GDP respectively, both fell rapidly soon after. By 1998,
the fiscal balance turned in a surplus, and the unemployment rate dipped
below 5 per cent-an amazing and unique achievement among European
countries. Japan is another case in point. Although its interest rates had
been very low throughout the nineteen nineties, excessive strength of the yen
was directly responsible for the bursting of the bubble, the stagnation of the
economy and surging fiscal deficits.

economy and its problems.
113
Chapter 11 will revisit the Japanese
3. RULES VERSUS DISCRETION, CURRENCY BOARDS,

AND COMMON CURRENCY AREAS
In recent years, interest rates are often hiked to avoid overheating so
the economic expansion can continue. By definition avoiding overheating
makes good sense, but what makes overheating is not totally clear.
Judgement as to whether an economy is overheating is necessary, and a
discretionary move in the interest rate is made on the basis of that judgment.
The market is left to speculate about how the central bank acts, and capital
flows and the security markets reflect these speculations.
Some economists believe that allowing so much room for the markets
to speculate is not conducive to stability. They prefer rules rather than
discretion. Rules are there for everybody to see, so everybody can act with
anticipation that the rules are to be followed. The currency board, with the
local currency effectively tied to a major currency, is one form of rule-based
monetary policy. Hong Kong and Argentina are examples of economies
adhering to a currency board system. According to many proponents of the
currency board system, in order to foster credibility in the system, economies
have to be prepared to take any economic pain required in defence of the
system. If confidence is lacking, a capital flight will take place, and the
outflow of capital will engender a tight money situation at home, potentially
taking the domestic interest rate to very painful levels. According to the
rules of the currency board, the monetary authority will have to be steadfast
and relentlessly allow the course of adjustment to take place. This must
involve unemployment and deflation at home. After all the painful
adjustment, the real exchange rate will have been lowered and interest rates
will have fallen back to more normal levels. Without the willingness to
take the pain of adjustment, the currency board will have no credibility, and
will not survive over the long run.
Because a currency board involves a currency linking to another
currency it is akin to the idea of a "currency area" with one common
currency.3 In principle, if the Hong Kong dollar is linked to the US dollar
at HK$7.8 to US$1 tightly and there is no question about the arrangement
ever going to change, there will be no reason why Hong Kong interest rates
should deviate from US interest rates at all. Any interest rate difference
should quickly lead to arbitrage that will eliminate that difference. If there
is no possibility that the Hong Kong dollar would devalue and if US interest
114
rates are lower, no one will borrow in Hong Kong dollars, and Hong Kong
dollar interest rates will decline.
In fact, however, the public perceives exchange risk to be real. So it
is possible that the interest rates of a currency board currency deviate from
the interest rates of the "host currency." During times of crisis, the "risk
premium" can be very high. To avoid such high risk premiums the option
of "dollarization" has been seriously considered in some currency board
economies which have linked their currencies to the US dollar. The
suggestion of dollarization should not be dismissed lightly, as between a
currency board that links with the US dollar and a fully "dollarized"
economy the advantages of the latter are overwhelming. The only real
disadvantage is the political cost of giving up the local currency as a symbol
of the identity of the country. There is the savings in transaction cost in the
form of not having to convert one currency into another. Exchange risk
and exchange risk premiums will be eliminated. Interest rates will be lower,
contributing to a more favorable investment climate.
Starting in 1999 many European countries have accepted the euro as
their common currency. For the time being it is circulating in electronic
form, but in time the euro bank notes will circulate and will replace the DM,
the French franc, the Italian lira, the Austrian schilling, etc. in the market
place. The European Central Bank will take charge and a uniform
monetary policy will be adopted. The euro zone certainly will be more
tightly integrated as one organic economic system. But each of the
constituent countries will no longer be able to depreciate or revalue its
currency independently. The euro is an unprecedented experiment. With
each constituent country being an independent fiscal system but all countries
using a common currency and subject to one common monetary policy, there
are risks that the prevailing monetary policy may be too tight for some
regions and too stimulative for others. If the former want to stimulate their
economies using fiscal policy deficits will occur. It waits to be seen
whether this bold experiment undertaken at the tum of the century will prove
to be successful in improving efficiency and promoting full employment
(Sala-I-Martin and Sachs, 1991; Ho, 1993).
4. CONCLUSIONS
Maintaining exchange rates and interest rates at levels compatible with
full employment is sometimes more easily said than done. The Thai central
bank knew that the Thai baht was overvalued but tried to defend it. That
led to a huge loss of foreign exchange reserves. In the end, on July 2 1997
it had to let the baht devalue. But the devalued baht was still under
115
pressure, and foreign exchange reserves had been drawn down to very low
levels. Further devaluation could lead to high inflation and panic and even
more capital outflow. Raising interest rates was, under the circumstances,
the natural way to stem the capital outflow in the short term, but it would
undermine the health of the economy in another way.
In the end the Thai central bank raised interest rates sharply, and
similarly did Indonesia and even Hong Kong. As expected the medicine
worked in the short term, but plunged the economies into a deep recession.
These economies all should have resisted raising their real interest rates,
if they had the choice. Instead, real interest rates were raised to backbreaking levels. If the United States had those real interest rates, the US
would have plunged into a deep recession all the same. With deep
recessions firmly in place, larger and larger fiscal deficits emerged.
How could these economies have kept their real interest rates at
sensible levels and contained capital outflow at the same time? The answer
lies in a credible international effort to achieve just this. The fact is: if the
currency has been devalued to a level consistent with the economic
fundamentals, the currency should be defendable at that level. An
international lender of last resort should come in and assure the financial
market that there is no more need to further devalue, and real interest rates
should be kept in line with international levels. This international lender of
last resort should not impose various conditions for lending that may actually
kill the patient.
In failing to deliver just this medicine that the ailing economies needed,
the International Monetary Fund attracted heavy criticism. Joseph Stiglitz
was particularly disappointed with the IMF, which was insistent in
prescribing a medicine of fiscal austerity. He wrote: "a student who turned
in the IMF's answer to the test question 'What should the fiscal stance of
Thailand, facing an economic downturn?' would have gotten an F." (Stiglitz,
2000) It is important that the whole world, not just the IMF, learn the
lesson about what constitutes a macroeconomic environment favorable to
growth and stability and work together to bring it about.
NOTES
2
3
A similar episode happened during the Great Depression in the 1930s. See Section 4,
Chapter 17.
The point that a restrictive monetary policy can trigger a recession was supported by
Ng (1999).
The path-breaking reference on optimal currency areas is Mundell (1963).
Chapter 11
SAVINGS INSTRUMENTS, BUBBLES, AND
FINANCIAL CRISES
We badly need to improve the financial market's intermediary function

between savers and investors. Savers need protection against inflation and
foreign exchange risks and seek a positive return. The absence of such an
instrument directly led to the formation of bubbles.
1. INTRODUCTION
Savers throughout the world are confronted with big dilemmas. No
matter what they do with their savings, there are big risks. There are
currency exchange risks, default risks, the risk that the real values of their
savings are eroded by inflation, bank failure risks. There is, of course, also
the risk that they may invest in dangerous bubbles. The problem is: even as
they want to get shelter from risks they may actually be contributing to the
formation of bubbles and are endangered by them.
This chapter tries to make a very simple thesis. The lack of a reliable
instrument whereby savers can invest their money and secure a reasonable
rate of return is at the heart of many financial crises. Inventing and
bringing about such an instrument, then, will avert many a financial crisis.
I cannot, of course, claim that most financial crises are due to the lack
of such an instrument. There are lots of theories explaining financial crises.
Crony capitalism, inadequate regulatory controls, greed, the lack of a
mechanism to avert moral hazard for banks, savers, and investors, overconfidence, herd behaviour, mishandling of initially containable
problems ... all have been said to have engendered financial and economic
crises.
It is difficult to prove or disprove these theories. There is certainly an
element of truth in all these theories, many of which can be attributed to
highly authoritative observers and analysts.
Harvard's Jeffrey Sachs blamed the IMF, saying that Asia was brought
to its knees in 1997-98 by a loss of confidence sparked by the IMF and its
118
prescription of tight credit and bank closures ("The IMF and the Asian Flu,"
The American Prospect, March -April 1998, 16-21).
The IMF blamed the Asian Financial Crisis to "weaknesses in financial
systems, and to a lesser extent, governance."
"A combination of
inadequate financial sector supervision, poor assessment and management of
financial risk, and the maintenance of relatively fixed exchange rates led
banks and corporations to borrow large amounts of international capital,
much of it short-tenn, denominated in foreign currency, and unhedged .... "
(The IMF's Response to the Asian Crisis, May 1998)
Lawrence Summers (then U.S. Deputy Treasury Secretary) believed
that "a combination of leverage and illiquidity" was the source of Asia's and
"most financial problems." (October 14, 1998 address to the Philadelphia
Bar Association) (USIS Weekly Summary, October 12-18, 1998)
Realistically, we should see financial crises as a system with a long
standing, potential problem being triggered into a crisis situation by one or a
Without the potential problem being there in
series of short-tenn events.
the first place, nothing would have happened. Without those triggers, too,
the crises need not happen at those moments when they happened. As long
as the potential problem remains, the seeds for crises will still be there,
however. When the time is ripe they will eventually lead to crises of one
sort or another. Although I agree with Sachs that poor management on the
part of the IMF and, in addition, poor central bank policy were largely
responsible for the gravity of the crisis, they cannot be the long-standing
problem. Rather, the lack of a reliable instrument for savings and
investment is the long standing problem and is at the heart of the Asian
Financial Crisis.
If the world's savers had access to an instrument that could provide
security and a reasonable rate of return, the fonnation of bubbles would be
less likely, and as a result the bursting of bubbles would also be less likely to
happen. We would have a financially safer, more secure, and less turbulent
world.
2. THE NATURE OF BUBBLES

Let us take Japan's serious economic troubles as a case study.
Japan's high savings rate is legendary and is sometimes held to be a positive
factor for the economy. Yet it is actually very much the source of its
economic woes. If the Japanese had consumed more, it would not have so
much money to pump into real estate. The current account surplus would
not have been so big. The yen would not have been so strong. And the
asset price bubble would not have fonned, let alone burst.
Savings Instruments, Bubbles, and Financial Crises
119
Imagine yourself being a Japanese in 1987. On the eve of the global

stock market crash of that year, the Nikkei index had already breached the
historical high of 26,000. At the time you knew that stock prices were high,
and you knew that Japanese real estate prices were extremely high. But
being thrifty and productive, you had to put your savings somewhere. It
would be logical for you to put some money in the stock market, some
money in real estate, and some money on overseas assets. Even if you
were so conservative as to put all your money into bank accounts, it is likely
that the banks will in turn lend the money to builders and home-buyers,
finance the purchase of assets overseas, or directly acquire overseas assets.
There being many others in the same boat looking for a place to invest
the money, it is no wonder that the Nikkei Index and property values
continued to rise. Helped by a temporary but sizeable depreciation of the
yen (see Table 1), by the end of 1989 the Nikkei was close to 39,000, while
property prices also went higher, indeed by as much as 59 per cent since
1987. When the yen hit a new high in 1991, however, it became apparent
that it made less and less sense to put more money into the domestic stock
market and the domestic property market. Interest in acquiring Japanese
assets reversed. Yet, thanks to an efficient manufacturing sector and a
highly successful export effort, notwithstanding large capital outflows, the
yen kept rising. The United States wanted the yen to appreciate in order to
curtail the trade deficit with Japan. Between 1990 and 1995, the yen-dollar
exchange rate moved from a low of 160 yen to the dollar to a high of around
80 yen to the dollar. As the yen appreciated, home assets, which were
denominated in yen became even more expensive to international investors.
The incentive to sell increased while the incentive to buy disappeared. No
wonder property prices and stock prices came down. A couple of months
after the yen's US dollar exchange rate peaked at around 80 yen to the dollar
in April 1995, the Nikkei had fallen below 15000. The land price index
had also been shaved by half. Commercial land was particularly hard hit.
About 60 per cent of the peak value was lost.
While domestic asset prices plummeted, the value of overseas assets
also declined in yen terms as the yen continued to appreciate against the
foreign currencies. Because Japan is a net creditor nation, by definition
Japan has more foreign-currency denominated assets than foreign currencydenominated liabilities. Appreciation of the yen will hurt the balance
sheets of Japan's business sector by reducing the yen value of net foreign
assets. It will then hurt indirectly those of Japan's banks even if the latter
were prudent enough to ensure that their own foreign liabilities match with
their foreign assets.
120
Table 1.
Year
Asset 2rices and exchange rates

Economic
Stock Price Index Property Price
Exchange Rate
Growth
Index
Yenl$
1997
1.4
15258.7
129.9
44.9
1996
19361.3
5.1
48.6
116.0
1995@
1.5
19868.1
102.9
54.7
1994
19723.1
0.6
63.2
99.8
1993
17417.2
111.9
0.3
71.4
1992
1.0
16924.9
124.6
87.0
1991###
3.8
22983.8
125.2
103.0
5.1
1990##
23848.7
135.4
100.0
1989#
4.8
143.4
38915.9
76.9
1988
6.2
30159.0
125.9
61.8
1987
4.2
21564.0
138.5
48.3
1986
160.1
2.9
18701.3
38.4
1985
4.4
13113.3
200.6
33.6
1984
3.9
11542.6
251.6
31.3
Source: Bank of Japan
Data for the Land Price Index is for comprehensive use in 6 major cities and is cited
from Statistics ofJapan 1998 published by the Statistical Bureau of Japan.
Note: Stock price indices are for end of the month at end of the year; the land price indices
are average values for the year.
#
1989 saw the stock market hit the peak and the yen hit a trough
##
1990 saw the property market jumping following the sharp surge in the stock market
the previous year.
### 1991 saw the yen rising to a nearly all time high having reversed a brief depreciation
against the dollar in 1989. Property prices peaked.
@
April 1995 saw the yen touching 80 yen to the dollar, then weakened rapdly. The
weakening of the yen triggered a dramatic rise in stock prices that lasted about a year.
Why did the stock market bubble burst in 1990 and the property price
bubble burst in 1991 is not an easy question to answer. Ito and Iwaisako
(1995) could not find a valid explanation for the stock price increase in the
second half of 1989 and the land price increase in 1990 using any asset
pricing model based on fundamentals or rational bubbles. The evidence
does show, however, that exchange movements certainly played some role.
We know that stock prices are much more sensitive to emerging economic
trends and they tend to lead property prices and turns in the macro-economy.
The yen's depreciation in 1989 increased the attractiveness of Japanese
assets and triggered a boom in asset prices. It also slowed the outflow of
Japanese capital. The excessive stock price increase, coupled with the
realization that the yen's depreciation in 1989 was only a temporary blip
triggered a sell-off in 1990. The sharp declines in the stock market in tum
aggravated the property sell-off in 1991.
121
One would ask why in the long years of secular appreciation of the yen,
from 360 to the dollar early 1971, through around 125 yen to the dollar in
1988, nothing serious happened. The evidence however is quite clear that
during these years Japan had invested aggressively in enhancing its
productivity and overseas. Through such investments, it managed to
preserve its competitiveness so that the manufacturing sector was still going
strong in 1988, notwithstanding an already strong yen. Over the years,
however, the accumulation of savings and the absence of alternative
instruments of investment inevitably had driven domestic asset prices to
higher and more dangerous levels.
The yen depreciation in 1989
apparently gave investors a pleasant surprise. The prospect of yen
appreciation having run its course drove investors to euphoria, and stock
prices climbed to new highs. When investors learnt that the yen was to
resume its appreciation, however, a major sell-off occurred.
In Hong Kong, there was a similar story. Like Japan, Hong Kong also
has a high savings rate. While Japan's high savings were fuelled by a very
successful manufacturing sector which enjoyed long periods of growth,
Hong Kong's high savings were not only fuelled by strong growth. For
many of Hong Kong's households, low cost public rental housing means that
they could save huge sums of money as their incomes increase. Indeed,
Hong Kong's public housing tenants were known to be the most cash-rich
and the biggest savers compared to private housing tenants, private housing
owners, or the subsidized homeownership scheme housing owners
(Watanabe, 1998):
In 1987 the government announced a new policy requiring the richer
public housing tenants to pay higher rents, even market rents for those
proven to have the ability to do so. 1 This sent a strong message to public
housing tenants, who then started to snap up private housing units in droves.
This sent the prices of entry-level homes higher. But the owners of entrylevel homes, finding that their homes could fetch good prices, also were in
the position to trade up, i.e., to buy better, larger, and newer units. During
a time of high inflation, trading up and otherwise investing in the home were
eminently sensible. The home was held to be the best inflation hedge. The
absence of alternative and reliable inflation hedges led to a long spell of
property price increase in Hong Kong that lasted through the hand-over of
sovereignty in 1997.
122
3. INDEXED GLOBAL BONDS AND THE WORLD

CURRENCY UNIT
These considerations lead readily to the idea of introducing better
instruments of investment for the world's savers. An ideal instrument
should protect savers against inflation and exchange risk.
These
instruments would be issued by borrowers of different stripes, including
sovereign governments. They will be rated for risk just as traditional bonds
are. Savers will buy those with the preferred risk-yield combinations
according to their own needs and preferences. These bonds, called indexed
global bonds, are to be denominated in what is called "a standard real value
unit of account." Because each of these units, by design, buy the same
amount of a composite world output, these bonds offer protection against
inflation risk as well as diversification for exchange risk. (See Ro, 2000.)
The proposed unit of account will be called the "World Currency Unit
(WCU)." It is based on the GDP of five major economies in a chosen base
year. The five economies all have totally convertible, freely traded
currencies, and include the United States, the Buro zone, Japan, Canada, and
Australia. 2 The sum of the GDPs in the base year, translated into US
dollars from their original currencies, is scaled down to equal US$100 and
forms the basic unit. Let QiO be the GDP of country i in base year 0, where
country i is one of the five countries/economic entities in terms of gross
domestic product. In the base year:
1 WCU = A. I QiO.e iO = US$ 100
where
[1]
A. is the scaling factor

i is any of the five major economies
e iO is the exchange rate converting one unit of the currency of i into
US$ in base year O.
As a constant value unit ("valun," to use Coats' terminology, see Coats,

p.7) the nominal value of WCU may change. No matter how the nominal
value changes, however, its real purchasing power is the same, because by
design it would buy the same basket of output. The nominal value, in US
dollars, at time t is equal to:
which merely says that the initial basket of goods should be revalued at
today's prices and translated into US dollars.
123
To the extent that bonds denominated in the WCD are available, savers
who need an inflation hedge can buy these bonds rather than properties and
stocks. Because such bonds are effectively based in a basket of currencies
and protected against inflation if a Japanese saver in the late eighties could
buy these bonds, he/she would have obtained a reasonable rate of return that
reflected the real rate of returns to investment, and would have been
subjected to minimal exchange risk. Similarly savers in Hong Kong could
have bought these bonds as a hedge against inflation rather than properties.
The excessive "bubble building" of the early nineties could have been
avoided.
4. THE NATURE OF SOVEREIGN RISKS AND THE
weu
International investors are familiar with the existence of "sovereign

risks." Sovereign risks are risks not directly stemming from the creditworthiness of the borrower per se, but are associated with the economic,
social, and political stability of the country in which the borrower is
domiciled. Exchange rate gyrations are one important aspect of sovereign
risk. If the currency of the country depreciates significantly, the lender will
inevitably get into deep trouble, no matter what currency the loans or the
bonds are denominated. If the loans are denominated in the local currency,
the repayment may be worth nothing when translated into the currency of the
lending country. If the loans are denominated in the lender's own currency,
the lender appears to be protected, but the borrower will have great difficulty
honouring the repayment. Either way the lender will suffer huge losses.
The fall of Peregrine Investment Holdings in Hong Kong in January
1998 was a case in point. Peregrine Investment Holdings was Hong
Kong's largest investment bank and had been highly profitable and regarded
by the investment community. Yet, because of the dramatic depreciation of
the Indonesian rupiah, it suffered huge losses and had to declare bankruptcy.
Because it had lent heavily to the well-connected Indonesian transport
enterprise Steady Safe, when the rupiah was caught into a free fall, Steady
Safe simply could not repay its debt. As recently as July 1 1997 the rupiah
was still trading at 2431 rupiah to the dollar. By January 1998 it was
trading at over 15000 rupiah to the dollar. Yet the Indonesian economy had
been considered an "outstanding performer" in the 1997-98 Pacific
Economic Outlook (PEO), which was published in 1997 by the Pacific
Economic Cooperation Council. The following were the exact words from
the PEO: "Given the challenges faced by Indonesia in 1996, economic
performance was outstanding. Real growth edged ahead, inflation dropped
significantly, and domestic investment grew at an unprecedented rate." (p.14)
124
While Indonesia had a large outstanding foreign debt, its current account
deficit in 1996 was only about 4 per cent of the gross domestic product and
was deemed sustainable (p.36). Although hardly innocent of corrupt
practices and nepotism, Indonesia's dramatic economic decline would not be
warranted by macroeconomic fundamentals. It was a victim to the
contagion, and Peregrine was in tum a victim to the economic melt-down
instigated by the plunge of the value of the currency.
Many commentators believe that the Asian Financial Crisis had much
to do with the problem of moral hazard. 3 The problem of moral hazard was
predicated on the explicit or implicit link of the various Asian currencies to
the US dollar, which had given investors a false sense of security.
Excessive lending to the Asian countries was attracted by high interest rates,
buttressed by the belief that there was little exchange risk. One could
blame the lenders for lack of the prudence to avoid excessive risk. One
could blame the borrowers for lack of the prudence to invest in more
sensible projects. But in this game even lenders and borrowers who are
highly reasonable and sensible get hurt. Once a currency gets into free fall,
If the
no one will be spared. Such is the nature of sovereign risk.
obligations were denominated in World Currency Units, it is highly unlikely
that a currency would go into free fall against the WCU. Both lenders and
borrowers would be better protected.
5. EXCESS CAPACITY AND BUBBLES

If the unavailability of a reliable instrument of savings is a contributor
to bubbles, so the lack of demand for final output is certainly no less
important a contributor to the bursting of bubbles. Particularly during
times of inflation, the urge to look for an inflation hedge may mean the
pouring of large sums of money into real estate or the stock market. Even
if money is invested in productive capital, however, the build up of excess
capacity may also lead to serious problems. In a sense, these two aspects
are closely related. If people spent more and saved less, there would be
less excess capacity and the amount of savings looking for investment
outlets would also be less. Some commentators have argued that excess
capacity was the "root cause of the [Asian Financial] crisis.,,4 Indeed, in
both Korea and Thailand very serious excess capacity problems in the
In a sense, the
manufacturing industries emerged prior to the crisis.
overbuilding of office buildings and even residential blocks are also a
manifestation of excess capacity. If the Japanese had spent more and saved
less, certainly its economy would have been stronger. Even today we
should worry as much about excess capacity and excess savings as about
125
overheating. Should Alan Greenspan raise interest rates and curtail

spending, or should he stimulate more demand to absorb the excess capacity
that is plaguing the world?
Adam Smith's insight sheds light on this question. Smith (1776/1961)
was vehemently against high interest rates. Rather than helping to allocate
the world's scarce capital efficiently, excessively high interest rates are
destructive. At eight or ten per cent, according to Smith: "the greater part
of the money which was to be lent, would be lent to prodigals and projectors,
who alone would be willing to give this high interest... A great part of the
capital of the country would thus be kept out of the hands which were most
likely to make a profitable and advantageous use of it, and thrown into those
which were most likely to waste and destroy it." (p.379)
6. CONCLUSIONS
Notwithstanding years of innovation and inventions, our financial
intermediaries have not performed very well. We have seen massive
problems in Japan's banks.
We have seen system failures in Mexico and
then in Asia. We have seen gyrations of the exchange rate under a freely
floating exchange rates system that crippled an otherwise strong economy
such as Japan. We have seen regimes of pegged exchange rates that led to
moral hazard and eventually had to give way to the free float. In the former
case a "floating exchange rate" floated out of line with economic
fundamentals and engendered an. economic decline. In the latter case a
pegged exchange rate parted with economic fundamentals, got so overvalued
that a crisis occurred. According to Ito, Ogawa, and SasakV one common
feature of the countries caught in the Asian Financial Crisis was a de facto
peg to the US dollar. The Thai baht was theoretically tied to a basket of
currencies, but "the US dollar had an overwhelming weight in the basket
since 1985." The Indonesian rupiah was on a slide system with a narrow
band, where the slide was adjusted for the inflation rate difference between
Indonesia and the United States. The Korean won had also informally tied
to the US dollar. Prior to the currency crisis of July 1997 all currencies had
appreciated in real terms vis-a-vis the US dollar. An important lesson from
all this is that the world's exchange rates should be realistic-should reflect
the fundamentals of the respective countries, so that full employment and
sustainable growth can be achieved. Neither floating exchange rate nor
pegged exchange rate can, by itself, prevent the exchange rate from
assuming unrealistic, economically damaging levels. Hot money flows
driven by changing expectations and political pressures can lead to
overvalued currencies in floating exchange rate regimes. Nominally fixed
126
exchange rates will also not work either, because of divergence in monetary
policy and real economic performance among countries.
My analysis suggests that the introduction of a standard real value unit
can help stabilize the financial markets and improve significantly the
financial intermediation function of banks. Investors can issue bonds
denominated in such units. As such bonds by virtue of their denomination
units are based in mUltiple currencies sovereign risk associated with major
exchange rate movements will be reduced. With sovereign risks minimized,
bond issuers can be assessed fairly and independently of sovereign risk
considerations for their own credit worthiness. Similarly, banks can offer
deposit accounts denominated in such units, so that savers holding money in
these accounts can be spared of the need to look for alternative, risky
inflation hedges.
Sovereign nations can, if they choose, link their
currencies to this unit of account. Because this unit of account has a
diversified basis, the likelihood of the home currency being subjected to
extreme devaluation or revaluation pressures will be smaller than if the home
currency were linked to a single currency.
If bubbles form when savings have nowhere to go but various asset
markets, it is globally rational to consume more.
An increase in
consumption will absorb the excess capacity of our manufacturing firms and
reduce global unemployment, and will restore the rationality of investing in
productive capacity. Only investing in productive capacity and in research
and development can enhance our welfare over the long term. If demand
for existing products is low, investments in productive capacity will not be
profitable. In contrast, investing in bubbles may be profitable-as long as
one could get away before others ahead of the bursting of the bubbles. This
was exactly what happened before the great stock market crash of 1929, as
we will see in Chapter 17.
Globally, therefore, we need more consumption at the turn of the
century. To stimulate more consumption and more investment, we need
lower real interest rates. This appears to run counter to the Federal
Reserve's policy. Given that the United States already has a very low
savings rate and is enjoying historically low unemployment rates, moderate
tightening is sensible. Globally, however, the world in 2000 still has a high
unemployment rate, widespread excess capacity, and a lack of interest in real
investment. Lower global interest rates will stimulate more demand and
foster a healthier investment climate. Contrary to what may be feared
lower interest rates will not cause bubbles. Bubbles are caused by a lack of
opportunities for productive investment and a lack of reliable instruments to
preserve the value of savings.
127
NOTES
3
4
5
According to Housing Authority (December 1990) "With the implementation of the

Housing Subsidy Policy on I April 1987, tenants who have resided in public housing
for 10 years or more with their houshehold income exceeding the Subsidy Income
Limit (SIL) are required to pay double net rent plus rates. The SIL is twice the
Waiting List Income Limit which is reviewed on an annual basis."
These economic zones are representative in that they comprise the world's major
industrial zones as well as major producers of primary goods.
Sarno, Lucio and Mark P.Taylor (1999) "Moral Hazard, Asset Price Bubbles, Capital
Flows, and the East Asian Crisis: the first tests" Journal of International Money and
Finance, 18,637-657.
Christopher Wood, "Embrace Creative Destruction, " The Wall Street Journal, October
13, 1988, p.A22.
"How did the Dollar Peg Fail in Asia?" NBER Working Paper 6729, September 1998.
Chapter 12
TRANSPARENCY
"If there is one thing I've learnt in government, it's that openness is
most essential in those realms where expertise seems to matter most. "
Joseph Stiglitz, The New Republic, April 17, 2000
" ... the East Asian financial crisis of 1997-1999 has highlighted twin
reform areas. These are financial sector strengthening and corporate
governance reforms ... "
Issues, PECC, June 2000
1. INTRODUCTION
The subject of transparency deserves much attention, not only because
it is frequently mentioned in discussions of financial crises, but also because
of its direct relevance to the subject of macroeconomic risk management.
In the past, it was not uncommon that central banks kept the foreign
exchange reserves secret. Even in Hong Kong, the composition of foreign
exchange assets was not disclosed until quite recently. Giving the markets
information about how much foreign exchange is held as reserves was
thought to be too dangerous, because speculators could observe its
fluctuations and would know the opportune time to attack the currency.
Even within the banking sector, the Hong Kong and Shanghai Banking
Corporation used to hold an "inner reserve" into which profits can be
transferred and out of which money can be paid out to stabilize the current
year's profit. There was then a total lack of transparency about exactly
how well the bank performs. This practice did not end until the early
1990s.
Is transparency good or bad for stability? In the science of military
maneuvering revealing one's strengths and weaknesses to the enemy would
130
be an unforgivable mistake.
transparency?
Why then is this criticism about lack of
2. TRANSPARENCY OF FINANCIAL REPORTING

While many other factors were also mentioned, both the Mexican peso
crisis in 1995 and the Asian Financial Crisis in 1997 had been attributed to
the lack of transparency in financial markets (Montgomery, 1996; Grenville,
1999; Rodrigo, 1998). Rodrigo thus said of the Asian Financial Crisis:
It resulted from the explosive conjunction of serious internal
flaws masked by lack of transparency, interacting with the natural

volatility of global financial markets.
The problem with a lack of transparency is that because market
participants do not see the problem when there is a problem, the problem
grows and remedial actions are delayed. The benefit arising from increased
transparency is therefore largely preventive. When one's actions are laid
open for everyone to see one would avoid doing things that are obviously
against the public interest. Without transparency one is apt to be less
responsible. Officers of banks may lend to people close to them at terms
that may not reflect the underlying risks and may lend when they should not
lend at all. Company directors may engage in insider trading or other
practices at the expense of shareholders and the public. Still another
problem is that without transparency market participants will be much more
prone to speculation and herd behavior as a self-protection mechanism.
Such behavior is consistent with human nature as discussed in Chatper 2.
It is true that if a bank gets into trouble, the trouble could magnify
when there is transparency. Depositors, realizing the problem, may all
move their funds away in self-protection even though the problem may not
be so serious.
This disadvantage of greater transparency will be
ameliorated once deposit insurance has been introduced into the system.
Because depositors are protected against the risks of their bank failing, large
scale bank runs can be avoided. Moreover, under a proper, transparent
form of corporate governance and the watchful eye of the market and bank
regulators, banks will behave, company directors will be accountable, and
the benefits from greater transparency can be achieved.
Transparency
131
3. TRANSPARENCY OF POLICY OBJECTIVES AND

TARGETS
If we want to have a more stable world with more stable financial markets,
we want to minimize surprises. One way to do this is to spell out clearly our
policy targets and objectives. In an attempt to reduce market uncertainty, the
Bank of Canada, for example, recently adopted explicit inflation targets and
modified its operational framework, hoping to achieve greater transparency and
minimize speculation (Gonzales-Hermosillo and Ito, 1997).
One key
advantage of currency boards, a subject now very much in vogue, is its
transparency and policy-by-rule rather than policy-by-discretion nature. Under
a true currency board system banknotes are issued against full (100 per cent)
backing of the linked currency at the official link rate. According to Kurt
Schuler, there are not many "orthodox," "true" currency boards around these
days. An orthodox currency board is supposed to be entirely passive, and
would not engage in any form of open market operations and would certainly
refrain from intervening in the stock market, like what Hong Kong did in
August 1998. A true currency board will have 100 per cent backing of the
currency, but even Argentina, whose peso is now tied to the US dollar at a oneto-one ratio, is not committed to 100 per cent backing. Like most things in life,
the benefits of a rule-based system have to be balanced against the costs. It is
well known that under a currency board system the monetary authority has
given up its discretionary power on monetary policy. Not only does the
exchange rate rise and fall with the anchor currency, interest rates also have to
follow that of the anchor currency. Not only do interest rates have to rise with
those of the anchor currency--often against the macroeconomic needs of the
local economy, but they also may have to rise more when the market is not fully
convinced that the currency board wi11last at the prevailing exchange rate.
But being rule-based and transparent does not necessarily mean that
the monetary system has to be a currency board in the "orthodox" sense.
I have proposed that Hong Kong adopt a system of linking the currency
with a basket of currencies under a currency board-like arrangement (Ho,
1990). Such a system is fully transparent as the proposed basket is
simply the well-known effective exchange rate index, which in the case
of Hong Kong is an index of the exchange value of the Hong Kong dollar
against 15 currencies including the US dollar. I proposed that the
official Hong Kong- US dollar link rate be continuously adjusted in order
to bring the effective exchange rate index to the target level. Exactly
because the rule is transparent, market speculators and arbitrageurs will
help achieve this. If, say, the US dollar rises in the foreign exchange
market, the Hong Kong effective exchange rate index will be pulled up,
l32
and the Hong Kong -US dollar exchange rate has to be reduced if the
original effective exchange rate is to be maintained. Before the official
announcement, therefore, market speculators and arbitrageurs will sell the
Hong Kong dollar. As a result the value of the Hong Kong dollar in
terms of the basket will be restored to the old level.
Alternatively, the monetary system can be one that is based on linking
with the World Currency Unit as suggested in the last chapter. The
mechanics are no different from that of a currency board and are fully
transparent. Compared to linking with one anchor currency, linking with a
basket of currencies or linking with the WCU will achieve greater flexibility
and stability.
4. CONCLUSIONS
Whether we like it or not, the world values transparency and is moving
towards greater transparency. The main benefit from having transparency
in corporate governance is increased accountability, so that people who
wield power will not be able to abuse their power. Potentially harmful or
unfair practices can thus be avoided. The benefit from transparency is
therefore largely preventive.
Rule-based policies are more transparent than discretionary policies. The
main benefit from having rule-based policies is reduced uncertainty. Because
rule-based monetary policies tend to be inflexible there is a price to pay for this
reduced uncertainty. However, some rule-based systems are more inflexible
than others. We have now the knowledge and the technology to adopt more
adaptive rule-based monetary systems. Currency-board-like systems that link a
local currency to a basket of currencies and to the WCU are superior to systems
They are less likely, through pulling the
that link to a single currency.
currency's exchange value up, to plunge the local economy into recession or,
though pulling it down, to drag the local economy into inflation.
I cannot agree more with Prof. Stiglitz about the importance of
intelligent, open debate on important public policy issues (see the opening
quote in this chapter). Although the subject of privatization of public
housing had been discussed for quite some time in Hong Kong before the
announcement of the Tenant Purchase Scheme on December 8, 1997, there
was no public consultation at all regarding the terms and conditions of the
final scheme. I was shocked when it was announced. Despite multiple
articles appearing in the South China Morning Post by this author criticizing
the policy (Ho, 1997d, 1998c), the scheme had been announced and offered
to tenants. As we can see in Chapter 18, the policy led to Hong Kong's
worst recession in history and plunged many homeowners into net debtors.
Part 4
RESOURCE ALLOCATION AND
REDISTRIBUTION
The market has traditionally been hailed as providing an ideal

mechanism for efficient allocation of resources. There are, however,
serious limitations to the market. There are very good reasons why the
market cannot replace the Government when it comes to providing certain
key services. Chapter 13 looks at the issue of "optimal government size."
The conclusion is that there is indeed an optimal government size, but it
comes about automatically after the right decisions have been made in
particular public policy areas. There is no point in trying to work out the
optimal government size in the first place. Chapter 14 and Chapter 15 take
a look at two important policy areas, namely education and housing, where
the role of the market and that of the Government are both indispensable.
Chapter 16 looks at redistribution issues, and suggests that what society
needs is a true safety net. I shall argue that Government has a key role in
providing "basic jobs." These Government-provided basic jobs form an
important safety net for the able-bodied. In addition the society needs an
income-based safety net for the more seriously handicapped.
Chapter 13
OPTIMAL SIZE OF THE GOVERNMENT
The concept of optimal size of government, like the concept of optimal

city size, is not very meaningful. A government or city with the "optimal
size" means nothing if it does not function well because it is ill-structured.
On the other hand, if all the government functions are taken up by the
government to the optimal degree and the people in charge are well
organized, the problem has been solved and there is no need to talk about
the optimal size of the government.
1. INTRODUCTION
All societies need a government. A number of important functions
have to be taken up by governments because the private sector is not in the
position to do the job fairly or properly. These include the maintenance of
law and order, fostering a favorable macroeconomic environment for the
private sector to operate ("macroeconomic risk management"), setting up
and running a social security system that provides a safety net for those hit
by misfortunes, ensuring the provision of infrastructure and those services
which may be under-provided if left entirely to the market. In the
Introduction to this book, I have maintained that any government that
satisfies the needs of society by delivering these needed goods and services
can be said to be a substantive democracy. In this chapter, I argue that if a
government takes up those tasks that it can do better than the private sector
can, and if it performs these tasks at a scale that is optimal, then the size of
the government will be optimal. The size of the government should not be
considered a public choice parameter because having achieved the "optimal
size" means nothing if the government is not doing its jobs properly.
136
2. BENEFIT -COST ANALYSIS AND BUDGET BALANCE

These days the financial markets expect governments to balance their
budgets. Whether we like it or not, a government that runs an ongoing deficit is
seen to be fiscally imprudent. Even though theoretically an ongoing fiscal
deficit can be part of a long run equilibrium and a growing economy could
service an ongoing fiscal deficit indefinitely if the debt-servicing cost is a fixed
percentage of the GDP, the financial markets will grow nervous. Largely
reflecting the widespread belief that prudent governments should balance their
budgets, while Europe prepared for the monetary union, the Maastricht Treaty
required that the fiscal deficit of any member country should be no bigger than
3 per cent of the GDP. In a similar spirit, the Basic Law of the Hong Kong
Special Administrative Region stipulated that the SAR government would
adopt a policy of balanced budget, and that the government "should spend no
more than its revenue." However, the revenue of the government is not fixed.
We can raise more revenue or less revenue. The edict of spending no more
than the revenue does not really specify how much to spend and how much to
raise. Ultimately, however, efficiency dictates that the government should
spend the money if the benefit of the spending is larger than the cost. So long
as the benefit justifies the cost, it makes sense to raise that extra revenue and to
facilitate that extra spending.
To put it simply, under the balanced budget requirement a government
can be bigger or smaller. Given the size of the GDP, if the government gets
bigger, the private sector gets smaller. With resources available to the
private sector being smaller, the real interest rate tends to go higher. But
this does not mean that a smaller government is always better than a bigger
government. Any government has to justify its size by looking at each
policy variable. When each policy variable is set right, the government is
optimal. There is no need to worry about the optimal size of the
government.
3. LAWS
Just like everything else, the introduction of laws and regulations involve
costs and benefits, and it is the consideration of these costs and benefits that
should determine whether a specific law is to be introduced. The costs
include the costs of legislation, the costs of compliance, and the costs of
enforcement. These costs include both economic and social costs. To
further the public interest, any law that brings more benefits than costs should
be enacted; any law that brings more harm than good should not be. In
Optimal Size ofthe Government
137
general, the more laws we introduce, the bigger will be the government, and the
more constrained private sector businesses and households will be.
There is really no point in saying that something by nature should or
should not be legal. In Hong Kong, it is an offence in law for passengers to
talk to the bus driver when he is driving. This would be unthinkable in some
other countries, but is obviously intended to ensure that the bus driver will not
get distracted. Nowadays, in many countries not wearing a seatbelt while
driving is illegal. Using a handheld mobile phone while driving is also illegal
in some places but not in others. To this day people are still debating whether
euthanasia should be legal or illegal. In some jurisdictions, drivers are not
allowed to make right turns when the red signal is on. In other jurisdictions,
they are allowed. Speed limits are set higher for similar roads and road
conditions in some countries than in others.
In general, laws define what behavior is acceptable and what is not.
Making a behavior illegal and hence punishable by law may bring benefits, in
the form of protection of citizens and their properties against the harm caused
by such behavior, greater peace of mind achieved for not condoning behavior
believed to be immoral, improvement of public safety and hygiene, etc. But it
also brings all kinds of costs. The test of whether a behavior should be made
illegal is really costs versus benefits and this is an empirical question that
needs to be studied carefully, case by case. Because values change over time,
the benefits and costs of laws will also change over time. What is legal today
may justifiably become illegal tomorrow and what is illegal today may
justifiably become legal tomorrow.
There is an ongoing and lively debate about whether addictive drugs
should be legalized, and this serves as an interesting case study for the
concept of optimal government size. Clearly, making drugs illegal will
increase government size. One would need a big anti-drug squad, a bigger
police force to fight street crimes, bigger and larger number of prisons, and
devotion of more court-time to drug and drug-related crimes. This is the
cost we have to pay. Are the benefits big enough to justify the huge outlay?
There is little question about the power of addictive drugs. They simply
overwhelm the physical system of the body and readily overpower the mind.
But is keeping drugs illegal an effective way of reducing drug addiction?
Many economists believe that drug law enforcers are spending too
much money on the war against drugs and that the costs of the drug laws
outweigh the benefits of the drug laws (Miron and Zwiebel, 1995; Niskanen,
1992). They argue that the huge public expenditure on fighting drugs and
crimes could be better spent on education and on health. Opponents to
drug legalization fear that legalizing drugs will lead to much more
widespread use of these drugs. More human beings will be enslaved by
drugs. Productivity and health will suffer.
138
Given the potency of powerful drugs, full legalization of drugs and

drug trafficking is risky. While the benefits of legalization could outweigh
the costs, the costs to health and productivity arising from more widespread
use and greater consumption could also vastly outweigh the benefits. It is a
gamble that responsible public policy makers cannot afford to make.
Still, we need to recognize that addictive drugs can never be
completely eradicated. What this means is that the fight against drugs has
led to higher prices and drug addicts are pushed into criminal activities and
drug trafficking rather than giving up the habit. In this light, destroying
seized drugs is really a silly thing to do. Rather than destroying these drugs,
seized drugs should be confiscated and administered to the known addicts
under security and clinical supervision. This would be the worst nightmare
for drug traffickers, because it will reduce the demand for street drugs, lower
street drug prices and undermine their profit.
What does this approach of criminalizing drug trafficking and
decriminalizing drug use mean for the size of the government? I suspect
that the size of the government will tend to go down, but we may need to set
up an official drug-buying agency that will buy quality drugs at the lowest
prices possible from countries where the drugs are available. This agency
would supply the drug clinics whose mission is to help drug addicts kick the
habit if they want to and feed the habit if they so desire. These clinics
would be manned by doctors, counselors, and other professionals. This
way, drug addicts would be treated like patients and we would reduce the
number of deaths from overdose or from taking drugs loaded with various
impurities. We would supply drugs to addicts at low cost while giving
them all the help they deserve to kick their habits. Drug smuggling and
drug pushing would still be a criminal offence punishable by law. Because
drug trafficking would become much less profitable but is still illegal we can
expect them to decline. Drug use can also be expected to decline.
This example about drug use decriminalization and drug trafficking
criminalization shows that the size of the government in the aggregate
should not be a policy variable. There is no scientific basis for limiting the
percentage of the GDP devoted to public spending at any pre-specified level.
4. GOVERNMENT SUBSIDIZATION OF ACTIVITIES

AND THE USER PAYS PRINCIPLE
There are two good reasons why the government should subsidize a
productive activity. The first is that the activity may bring benefits that are
external to the producer, so that the output may be under-provided if not
139
subsidized. The second is that the activity may involve heavy fixed costs, so
that charging users the marginal (direct) cost of the service will not pay for the
full costs of setting up and running the facility.
The external benefit argument is discussed in most textbooks and will not
be elaborated here. The heavy fixed cost argument is discussed in some
books, I but is not as well known. In particular, it is common these days for
governments to assert the user pays principle in providing services, as if every
service should be self-financing if it is to be efficient. Nothing is further from
the truth. Unfortunately, people do not recognize that the user pays principle
really says that users should pay the full marginal cost of a service ("marginal
cost pricing"), but not the full average cost. Requiring users to pay the full
average cost is often inefficient. On the other hand, having to subsidize users
for the use of a service on an ongoing service can be most efficient. All over
the world, most underground mass transit systems require governments to
subsidize their operations. Because underground mass transit systems are
very costly to build and to operate, requiring users to pay the full average cost
so these systems could operate without a loss is generally unrealistic, except in
places like Hong Kong where the density of the population and the volume of
passenger traffic are exceptionally high. Yet most people would agree that
these systems are mostly a good investment for the economy. Charging
passengers below the full average cost is the only way to keep these systems
optimally utilized. Even if it is possible to charge higher fares and to make the
systems profitable it will be socially undesirable to do so?
5. PRIVATIZATION OR GOVERNMENT-RUN
OPERATIONS?
These days it is also widely believed that privatization is good. If there
is no overriding reason for the government to step in, such as to defend the
public interest when there is a major divergence between social and private
costs or benefits, the private sector should take over the operation. The
government should only retain those activities which the private sector simply
cannot engage in because of a potential conflict of interest or because it cannot
possibly maintain itself.
Although belief in a small government and in privatization certainly antedated Margaret Thatcher, there is little doubt that Thatcher is the single most
influential missionary for the gospel of privatization. However, having looked
at the evidence from the experience of privatization of many countries,
Tittenbrun (1996) concluded that "the available evidence on productive
efficiency performance of public vs private enterprises is insufficient to prove
140
that the former are inherently less efficient than the latter." (p.115) Ownership
is not the most important determinant of efficiency. Rather, the existence of
competition or the lack of it has much to do with efficiency. Tittenbrun
further noted that, since some industries are characterized by large fixed costs
and significant economies of scale, the allocatively efficient level of output and
price would lead to a loss for the producer and is not feasible as a pure market
outcome. It follows that profitability cannot be used as a reliable indicator of
allocative efficiency. A profit-maximizing firm in a decreasing cost industry
will set output and prices at levels different from the optimal levels.
Tittenbrun (1996) notes correctly that publicly owned enterprises tend to
be subject to greater political pressure than private enterprises. He found "a
lot of evidence" suggesting that politicization is the main cause of the
"inefficiency" of public enterprises that do not perform so well. As a result,
public enterprises may have greater difficulty in laying off redundant staff, may
pay higher salaries than will their private counterparts, or may provide more
generous fringe benefits. From this light, the problem of "inefficiency" for
public enterprises may be more a redistribution issue than an efficiency issue.
In China, the reform of state owned enterprises is beset with one big problem,
which is the public policy consideration of avoiding excessive unemployment
and social instability. If these enterprises are doing all these things, which
may be desirable in their own right, then not being so profitable may not
necessarily mean that they are intrinsically inefficient.
From the public policy point of view, it is important to ensure that
enterprises, private or public, are accountable and that they operate under an
environment of fair competition. If public enterprises are implicitly given
policy responsibilities, we should ask ourselves whether these policy goals are
really important and whether giving public enterprises such responsibilities is
the best way of achieving the policy objectives. Public enterprises need not be
fmancially self-sufficient, if they are characterized by large fixed costs and
significant economies of scale. But subsidies should be in the form of
lump sum payments rather than in the form of underwriting against losses per
se.
6. EFFICIENT TAXES AND REVENUE SOURCES

If governments should be as large as it is economically efficient to be,
we will need to raise sufficient taxes or alternative revenues to run them.
Revenues can take one of two forms: land-based revenues and non-land
based revenues. In a growing economy land-based revenues can be very
important and can dominate other forms of revenue.
141
Hong Kong is a case in point. For years it had been the envy of the
world. Economic growth had been sustained for three decades at high rates;
tax rates had been the most favorable known to the world; and land prices,
though high and rising, had not undermined the former British colony's
ability to compete in the world. Capital continued to be attracted to Hong
Kong, while Hong Kong products continued to sell all over the world.
Hong Kong's success testifies to the validity and viability of the Henry
George tax model, which says that we can keep tax very low if the
government taps its revenue from land, and that is economically efficient.
Notwithstanding the "bursting of the property bubble" after the
handover of sovereignty, I maintain that, for Hong Kong as for other
economies, keeping taxes low and tapping land for revenue is the way to go.
Traditionally, the Hong Kong government sells land leaseholds in public
auctions, collects land premiums from land developers that convert land use
from one use to another, collects stamp duties from land transactions, shares
the profit of land developers and banks that finance mortgage loans through
the profits tax.
If taxes are kept low the private sector will be encouraged to invest and to
produce, since the product of hard work will not be taxed away. Provided that
law and order is maintained, social and political stability is maintained, the
bureaucracy is free from corruption, and the government allows the market to
operate freely, the private sector will deliver the best of entrepreneurship and
will invest aggressively. Land prices will rise, and the government will collect
handsome revenues both directly from land and indirectly from land through
profits and income taxes. This is the success story of Hong Kong over the
thirty years before the handover of sovereignty. As to why Hong Kong's
property bubble burst, Chapter 18 will give a full explanation. Suffice to say at
this point that property prices may rise or fall in the short-term, but secular
economic growth means that over the long run property prices will rise, and land
remains an excellent and dependable source of government revenue.
7. CONCLUSIONS
Optimal resource allocation means that every type of resource should
be put into one use as long as that use brings more benefit than if it were put
into another use. This is true within the public sector, within the private
sector, and between the public sector and the private sector. The test of
optimality is always marginal benefit--marginal cost comparison. Any
attempt to bring in any form of "rules of thumb" constraint to public
spending is unscientific and anti-welfare. There is no need to worry about
142
the "optimal size of the government." Instead, we should keep asking

ourselves: do we have the right policy and the optimal policy parameters?
NOTES
For example, Richard Lipsey and Paul Courant (1996) Economics, 11th edition, Harper
Collins, p. 267-268.
See Frankena, Mark W. (1979) Urban Transportation Economics: Theory and
Canadian Policy, Toronto: Butterworths, Chapter 5.
Chapter 14
EDUCATION POLICY
"The adults in schools must have the power and the authority to make
decisions on the spot, decisions that may differ from school to school,
depending on the circumstances and the individual children involved. "
Diane Ravitch, Introduction,
Brookings Papers on Education Policy 2000
1. INTRODUCTION
There are plenty of studies that show that education provides attractive
rates of return. Both social and private rates of return have been estimated
at double digit levels (Psacharopoulos, 1994) for most countries, although a
more recent study came up with a much lower, approximately 6 per cent
social rate of return to education for the UK (National Committee of Inquiry
into Higher Education, 1997), The reason why estimates of the social rates
of return are always lower than those for the private rates is that the
calculation of the social rates of return takes into account the social
investment into the education process. Private rates of return, on the other
hand, are estimated on the basis of the private opportunity costs of acquiring
the education. It should be noted that, typically, estimations of the social
rates of return ignore external benefits on society such as lower crime rate
and increased literacy that allow more effective functioning of the
government. The importance of education is widely recognized and is
reflected by the large budget devoted to education by governments all over
the world.
Foremost in the agenda for an education policy is curriculum design.
Education builds various kinds of skills and influences the way people
perceive themselves and the world. Skills obviously directly affect an
individual's ability to engage in economic production and in "household
production." Because what counts in one's utility function include both
tangible and intangible qualities or "attributes," as had been discussed in the
chapter on human nature (which include "mental goods" and "mental bads"),
144
the design of the school curriculum is of utmost importance. The school

curriculum certainly should cover general job-related skills, communication
skills, and cognitive skills, but it should also cover "life skills." Life skills
include social skills, stress management and coping skills, problem-solving
skills, and self-management skills. Education should contribute to the
production of happiness-enhancing attributes such as self-respect and the
respect for others, and help people minimize the production of happinessameliorating attributes, such as self-pity and jealousy.
Another important policy concern is to create an environment that
encourages the emergence of quality schools and quality students. Crucial
to this is a system that respects autonomy, choice, and fair competition.
This provides the environment that will promote the efficient production of
education output.
Assuming that we have an environment that allows the education
output to be produced efficiently, the next important policy question is what
constitutes the optimal combination of quality and quantity of education
output. Assuming efficiency, quality would be equivalent to providing
more input per student-year. Quantity has two dimensions: the number of
years of education per student, and the number of students enrolled in each
level and each type of education.
Still another important policy concern is the funding of education.
Should education be publicly funded? How about private schools?
Should students bear a part of the cost of education and if so, how much?
Finally, there is the question about the diversity of education. Should
we provide more vocational or professional education or more general
education? How shall we decide between this mix?
This chapter will explore these questions using the framework
introduced in the beginning of this book.
2. CURRICULUM DESIGN
This is not the place to discuss the details of curriculum design. One
basic principle of economics, and one that we must bear in mind, however, is
that all components of the curriculum compete for the student's scarce time.
There should therefore always be a "systems perspective." Rather than
each subject trying to defend its turf we should consider the total time
available and the balanced needs of the student. Only those components
which will serve the student's long term interest best should be included.
As much as the authorities may want to dictate the full curriculum on
schools, they should not preempt schools and teachers, who should be given
the autonomy to bring into their school curriculum elements that they regard
Education Policy
145
important for the children under their care, for they have direct contact and
interactions with their students and know their needs and abilities better than
anyone else. Over the years each school may have its own success stories
and schools can then learn from one another.
There is no question that basic language literacy and numeracy skills
are essential to effective communication and learning so the school
curriculum must definitely provide adequate coverage of these subjects.
Students should clearly also learn to know more about their own community
and the world. But more important, they should learn how to live
peacefully with others and with themselves. The way to do this is not to
tell them what is right and what is wrong, but to go into history and literature
and human case studies to alert students to the consequences of alternative
ways of life and let students decide for themselves what is right and wrong.
As the chapter on human nature argues what affects human happiness
is not just market goods and services but also mental goods and mental bads,
which are in turn affected by perceptions and attitudes. A school
curriculum that helps create mental goods and eliminates mental bads is
economically as productive as firms that supply market goods and services
are. This is over and above the human capital investment aspect of
education. It is useful to use the example of the concept of success for
illustration. A feeling of success or achievement is certainly conducive to
happiness. If the education system builds a concept of success based on
relative performance a large number of school children will suffer from a
totally unnecessary mental bad. When success is interpreted in relative terms,
students tend to see others as enemies rather than friends. On the other
hand, if the education system builds a concept of success based on reaching
new heights for each person, then all school children (and future adults) will
be able to enjoy the mental good called "success" as long as they all try hard
and realize their own potential.
Designers of school curriculum should realize that many children come
from unhappy families. They need to learn how to relate to their parents
and brothers and sisters and friends, particularly how to respond when they
are unreasonable or even mean. School children should also learn about
parenting. Only when they know how to be parents and learn about the
problems faced by parents can they relate to their future children, and can
they communicate more effectively with their parents.
The authorities should standardize only part of the school curriculum
and probably a greater part for lower grades but should exercise less control
for higher levels of education. Students in higher grades should have
greater choice over programs and curricula, which may be more vocational
and career-oriented or more academically and intellectually oriented,
depending on their aspirations.
146
3. EFFICIENT PRODUCTION OF EDUCATION

Maintaining Fair Competition and Standards of Excellence
Efficient production of education requires motivated teachers and
motivated students. Among other things, a necessary condition for teachers
to be motivated is that they can see the results of their own effort. If, for
historical or other reasons, a secondary school keeps getting the best students
year after year while another keeps getting the worst students year after year,
teachers in the "good" schools may find that they can put in a minimum
effort with little apparent adverse effect on performance. On the other hand,
those schools that keep getting the worst prepared students may find that
they are being unfairly treated, because teachers in these schools never get a
break. Students groomed to become competitive would leave for schools
with better names, while new enrollees continue to be poorly prepared.
Generally, a system that allows students to compete for school places
will end up with preferred schools with preferred students. Such a system
is good up to a point. There is no harm and indeed a lot of good in putting
the sharpest minds together. But if the whole lot of students are ranked and
slotted to schools that correspond with their ranks it is likely that some
schools will be labeled "undesirable" and will be left with "undesirable"
students. Such a system will inevitably create a lot of pressure on students
and parents. To the extent that schools that are least preferred are assigned
the worst-performing students there will be a labeling effect on these
students and the teachers in these schools will have a hard time helping the
students overcome their sense of failure. Under such a system the fear for
being assigned a lowly rated school will put great pressures on students and
parents. Such a system, which allows some schools to take the best
students and forces some others to take the worst students is, however, most
definitely a socially destructive and an inefficient way to educate our
students. It is socially destructive because at an early age students are trained
to see success in relative terms. Given such a system, it is no wonder that
primary school students in Hong Kong felt so much pressure from the public
examination that would categorize them into the five bands. l It is also
highly inefficient because teachers in the preferred schools will not need to
perform in order to attract good students, while teachers and students in the
to-be-avoided schools are demoralized. Students tend to see themselves as
failures and teachers have a rough time maintaining order in class, let alone
teach effectively.
Education Policy
147
Actually, in order for schools to run efficiently, a dose of healthy

competition, allowing students and schools to compete on an equal footing is
highly desirable and even necessary. One proposal is to allow the top 10 or
20 per cent of students from a public examination to choose their own
schools. This is just like the current banding system in Hong Kong. The
remaining 80 to 90 per cent of students will, however, be randomly allocated
to various schools according to the nearest location. This way, the most
preferred schools may continue to have the best students for a while. If
they do not perform well, however, anyone of the other schools may attract
away the outstanding students in the next rounds of public examinations
from them. The other schools will enroll students covering a whole range
of abilities.
Under this arrangement, if students do very well they will have their
choice of the secondary school, but if they do not do so well, it is not the end
of the world. There will still be elitist schools. A typical secondary school,
however, will have a student body with a full range of abilities. For
maximum teaching efficiency students of similar abilities may be grouped
together. Because this is done within the school any labeling effect will be
kept to a minimum. Moreover, provided a student improves he can easily
move up to a class for higher abilities. Such a "migration" is certainly
easier within a school than from one school to another.
The Role of Public Examinations

Both public examinations and the presence of elitist schools that will
take the top students from the public examinations are necessary to instill a
sense of purpose and to generate greater awareness of one's performance.
Both will help enhance efficiency. Because all the other, non-elitist,
schools have a similar student base they can compete on the same footing.
Provided that they build up sufficient reputation they can attract the top 1020 per cent of students and become one ofthe elitist schools.
Empowerment of Parents and Autonomy of Teachers

Also important to the cause of efficiency is respect for teachers'
autonomy. Teachers working in the classroom know best how students
respond to different teaching methods. Bureaucrats can provide schools
and teachers with information and different perspectives, but should really
leave it to the teachers as to how they go about teaching their students.
148
Principles ojPublic Policy Practice
This principle finds testimony in Bill Clinton's praise of the charter schools
in the US. Charter schools are public schools that operate with little
government intervention and union interference. According to Clinton,
"We now have enough evidence that the charter school movement works ...
Very often we see charter schools provide an even greater atmosphere of
competition that induces kids to work harder and harder to learn.,,2
While it pays to give teachers greater autonomy to exercise their
professional judgment and creativity in the classroom it should be
recognized that teachers are human beings and are subject to their own likes
and dislikes and human weaknesses. Like all workers and professionals
they should also be held accountable. A recent issue of the World Bank
Economic Review contained studies suggesting that it pays to give parent
Positive results in
greater involvement in the management of schools.
terms of lower dropout rates, lower teacher and student absenteeism, and
more effective learning (Volume 13, September 1999) from parent
participation in school management have been documented.
In recent years, there is more and more discussion about the use of
education vouchers as a way of enhancing efficiency and choice. The idea of
education vouchers is to allow parents and students to have choice outside the
public school system for education. The subsidies implicit in a public school
place can, under the voucher system, be transferred, if the student so chooses, to
a private school of his own choice. The biggest fears about an education
voucher system are two. First, while in principle students can choose schools
under the voucher system it could end up with schools choosing students based
on socio-economic background, as a result of which there could be social
segregation and less equal opportunity rather than more. Second, allowing
students to opt out of the public school system could undermine the finances of
the public school system and hurt those students that remain in public schools.
As long as these problems can be contained, perhaps through limiting the face
value of vouchers to only a fraction of the funding support implicit in a public
school place, the voucher system, by enhancing choice and competition, should
have positive effects on education quality.
There is an imperative to defend and improve the public school system.
A good public school system is our chance to ensure equal opportunity to
education. A completely privately funded school system would leave out
children from the poorer families. Having a public school system and at
the same time allowing students to take part of the funding to a private
school3 not only will give students from poorer families the choice to enroll
in private schools, but will give public schools a healthy dose of competition.
However, allowing students to take the full funding to a private school will
drain too much resource out of public schools and will put them at a
disadvantage.
Education Policy
149
4. FUNDING
Considerations about social justice and equity dictate that the
government should ensure that basic education is available to all. This
would mean that the public purse should fund basic education. Funding
basic education is not restricted to paying for the running cost of schools but
also implies paying for a significant percentage of the training cost of
teachers. This is to ensure that a career in teaching is sufficiently attractive
to high quality candidates. Given that a good primary education is an
important aid and even a prerequisite to a good secondary and even
university education, the returns to primary education have often been
underestimated, as pointed out by Appleton, Hoddinott, and Knight (1996).
Making sure that teachers are well qualified and motivated, and equipping
schools adequately is well worth the while.
As argued earlier, those parents who choose to send their children to
private schools should have the prerogative to do so, provided that they take
only a fraction, perhaps fifty per cent, of the average funding cost to the
public school system.
A big question is whether the government should provide sufficient
funding for post-secondary education to be accessible to all who want it.
The argument in this book is that each student should get the education
he deserves. Everybody deserves basic education, but not everybody
deserves higher education. Higher education investment should be made
only as long as the benefit is larger than the cost. The benefit of higher
education investment is larger than the cost for some individuals but not for
others. The investment in quantity should be made only as long as the
marginal net benefit from extending the education to the next competent
student is positive. The investment in quality should also be made only as
long as the marginal net benefit from spending more on an individual is
positive.
Since higher education brings returns to the individual, is there a reason
to use public money on higher education at all?
Public subsidization of higher education will raise the private rate of
return from education. This will make the study program more attractive.
If the opportunities for enrolling in these programs are limited, the subsidy
will make the program more competitive. The increased competition will
increase the quality of students enrolled in those programs. So the question
we should ask is whether the benefit of having better-qualified students to
enroll in these programs outweigh the costs. For example, making medical
students pay a greater percentage of the cost of their education will reduce
the private rate of return for enrolling in the medical school and will reduce
the attraction to students. Competition for the medical school will become
150
less keen. As a result the quality of students enrolled in the medical school
will decline. Public spending on medical education therefore can be seen
as a spending to enhance the quality of our future doctors.
5. CONCLUSIONS
Education prepares a person for living in the society. Living in the
society means work, socializing, being with one's own family and being
with oneself. Certainly education means a lot in terms of happiness, both
for the one receiving the education and for others. The curriculum is of
utmost importance because a badly designed curriculum will certainly result
in our younger generation badly prepared for society when they leave
school.
Giving parents the choice between public school and private school is
fine as long as the public schools are fine. It would be tantamount to giving
up the poor and depriving children from poorer families the opportunity to
decent education if the public school system is poor. Giving poor parents
education vouchers to buy education in private schools is not the answer.
As Lazear (1999) testifies, quality private schools charge high prices.
Giving parents education vouchers and giving up the public school system is
abrogating the responsibility of providing a decent education to all. Public
schools should be given a fair chance to compete. They should be given
adequate resources and should be allowed to tap students covering a full
range of abilities. Within the public school system the choice to opt for
personally preferred schools should be given only to the top 10 to 20 per
cent of the students. If schools tap different qualities of students they will
not be able to compete fairly.
In principle, investment in education should be carried to the point
where the marginal benefit of extending the education to more people is
reduced to equate with the marginal cost. This means that a blanket
statement in favor of universal education at all levels for all is not warranted,
unless it can be proven that extending the education to more people
continues to yield net social benefit. In general, the latter is probably true
with basic and perhaps even secondary education, but quite unlikely with
university education. For an individual, optimal education investment
requires that he receive as many years of education as it takes to reduce the
marginal benefit of an extra year of education to the cost of doing so. It is
highly unlikely that the optimal "intensity" of education would be the same
for all individuals, with their different aspirations, interests, and abilities.
Before extending the number of university places, therefore, we should
assess the marginal benefit and marginal cost of doing so. A good place to
Education Policy
151
start is to assess the extent to which existing university students benefit from
their degree programs and whether there are other social benefits or costs.
Since enrollment in a university is voluntary, we may assume that the
fact student continue to enroll in university suggests that the private rate of
return from university education is sufficiently attractive. The latter seems
to be borne out by various studies. For example R. Blundell, L. Dearden, A.
Goodman & H. Reed (1997) found a substantial wage premium, between 12
and 18 per cent for men and between 34 and 38 per cent for women, enjoyed
by university graduates over non-university graduates.
Such wage
premiums calculated for the average university graduate, however, do not
imply that we should expand university enrollment, because "marginal
students" may not benefit from the education and may earn much lower
returns. The fact that students enroll in universities in expectation of gain
is not good enough a reason for expanding enrollment. Students may think
enrolling in university is a good gamble. But from the social point of view
it may not be. People are known to take actuarially unfair bets. That does
not mean that socially the bets are worthwhile. Extending university
education to an additional student may entail a marginal cost that is larger
than the expected marginal benefit.
The extent of unemployment among university graduates in many
countries such as the Philippines and India suggest globally and particularly
among less developed countries, higher education enrollment ("quantity") may
have expanded too fast when in fact the investment should have been in quality.
Widespread illiteracy or half literacy suggests that for basic and secondary
education investment in both quality and quantity has been inadequate. Grim
career opportunities awaiting many university graduates in a number of
countries suggest that investing in quality, rather than quantity, is the way to go.
It is high time we use benefit-cost analysis, rather than political rhetoric, to
determine the further development of education.
NOTES
2
3
This is the system in place in Hong Kong for many years. The Special Administrative
Region is proposing to collapsing the five bands into three. This is far from adequate,
as students enrolled in the third band will continue to be labeled as failures.
Quoted in Abby Goodnough, "Clinton seeks some control of charter schools," The
New York Times, May 5, 2000.
Alberta in Canada offers students the opportunity to take half of per capita public
school cost to private schools. See West (1997).
Chapter 15
HOUSING (WITH A DIGRESSION ON
TRANSPORTATION PRICING)
Those in charge of housing policy should be mindful to maintain the

"flow" in the housing market. Public involvement in the housing market
should be limited to providing the low-income households with decent but
basic shelter; otherwise it would preempt the private market.
1. INTRODUCTION
Governments throughout the world, regardless of their ideology and
political orientation, have participated in the housing market to a greater or a
smaller extent. Food and shelter are regarded as basic human needs and
both certainly receive considerable attention from governments.
Food and housing are "private goods" which are bought and sold in the
market place. Yet if people cannot afford food and housing malnutrition
and poor housing conditions result. This is regarded as unacceptable in an
affluent society. In principle, an income transfer could allow the poor to
meet these basic needs and exercise some choice, and it could be superior to
a transfer in kind. But the poor, on receiving an income transfer, may not
spend it on food and housing to the extent most people feel comfortable.
This is why governments often choose to issue food coupons and to
subsidize housing. For this reason housing can be called a "merit good."
Public policy to boost housing consumption among the poor can take
the form of demand-side subsidy, supply-side subsidy, or outright production
for the poor. The problem with demand-side subsidy is that the subsidies
may end up boosting the rental income of landlords without improving the
housing conditions of the poor. Because the poor have little means to buy
new housing, housing for the poor is never commercially profitable to build.
As a result the poor rely on a process of "filtering down" to obtain their
accommodation. Filtered-down housing refers to old, run-down housing
vacated by those who have become better off and able to move for better
housing. If the supply of such filtered-down housing is limited and
154
inelastic with respect to rent, giving the poor rental subsidies may benefit
landlords more than tenants.
This is why typically governments use supply-side measures to help the
poor live in better housing. Contracting out the construction, subsidizing
production, or taking charge of the construction directly, many governments
make sure that new housing are built for the poor according to certain
specifications and avail such housing to those satisfying specified eligibility
criteria at subsidized cost.
2. SUPPLY OF RENTAL OR OWNED HOUSING?

For many years-indeed over two decades up till 1978-Hong Kong
provided low-cost rental housing for the poor. Singapore's Housing and
Development Board (HDB) went the other way. Singapore's Home
Ownership Scheme was introduced as early as 1964. Because Singapore
adopted the subsidized home ownership approach from an early day, today
over 90 per cent of families living in HDB flats owned their homes. In
contrast, on the eve of the transfer of sovereignty more than 70 per cent of
Hong Kong's public housing population lived in rental flats. In terms of
coverage, Singapore's public housing program had provided homes to 86 per
cent of the entire popUlation, a ratio far higher than Hong Kong's 50 per
cent.
The public housing program in Hong Kong was from the first day
intended only as a kind of interim housing. It was very low-cost and very
low quality, although today quality has improved significantly. The public
housing program in Singapore, in contrast, was intended to provide
permanent, quality homes even in the early sixties. According to the HDB,
"Even towns built in the early years, such as Toe Payoh town come complete
with a town centre, children's playground, swimming pool, shops, markets,
cinema, library, and light industries to provide employment for residents.
All the transportation and commercial facilities are also linked up to serve
residents." 1
The public housing program in Hong Kong was intended to help the
poor; that in Singapore was to help the poor and the middle-class people as
well. Obviously Hong Kong's model left much more room for the private
sector than the Singapore model.
More important, because the low income people in Hong Kong paid
very low rents (less than 10 per cent of the median household income among
the tenants) and because the economy had gone through years of strong
growth, many households in the low cost rental housing were able to
accumulate a huge amount of savings. When the Home Ownership Scheme
155
(HOS) housing was first introduced in 1978, the 8400 units attracted 36,000
applications, many of which were from public housing estate tenants. As a
matter of fact, the government intended that the public housing estate tenants,
by purchasing HOS units, would vacate their rental units and make room for
those waiting in line for public housing. This is why public housing tenants
were exempted from the income eligibility requirements that would apply to
other applicants for HOS housing. HOS housing was priced at a 30 to 50
per cent discount from estimated market prices. Successful applicants for
HOS housing were selected through a lottery, and from the first day until
1997 obtaining a ticket to buy HOS housing had been considered equivalent
to winning a lottery.
In Singapore buying and owning a HDB housing flat was encouraged
through the following means:
From 1968, Singaporeans were allowed to use their Central Provident

Fund savings for the 20 per cent downpayment and monthly repayment
of the mortgage loan;
The income ceiling is frequently reviewed "such that every 9 out of 10
Singaporeans are eligible to enjoy the benefits of public housing."
Buyers are charged very low, HDB-sibsidized interest rates and had the
option to repay the mortgage loans over a period up to 25 years.
Rental tenants are offered a discount of 30 per cent off the selling price,
or S$10,000, whichever is lower and can obtain a mortgage loan of up
to 100 per cent of the discounted price.
Compared to Hong Kong's property prices, HDB homes are quite

affordable with prices in 1998/99 ranging from about S$130,000 to
S$400,000. Because HDB homes account for 86 per cent of Singapore's
population and clearly dominates the market. In other words, the HDB
"calls the shots." Although since 1991 private developers have been invited
to tender for the design and construction of public housing flat, they continue
to have only a tiny room to play in Singapore's housing market. However,
there is no discontinuity in the housing policy.
In contrast, Hong Kong's housing policy underwent a few rather
significant changes. These included the introduction of HOS housing in
1978, a policy to make the richer tenants pay higher rent that was first
endorsed in 1986, and the announcement of the Tenant Purchase Scheme in
December 1997, which allowed sitting tenants to buy their units at a deep
discount.
To provide an option for richer tenants to buy better, less subsidized,
housing was a great idea. The policy to make the richer tenants pay higher
rent was also a great idea. Both policies increase the "flow" in the housing
156
market. Tenants whose economic circumstances had allowed them to move

out of subsidized rental housing moved out. Those waiting in line moved
ahead. The richer tenants also moved onto better housing.
The policy in Hong Kong for many years had allowed HOS owners to
resell their units in the open market after 10 years. Many of them did, and
they realized a good profit (they had however to pay back to the Housing
Authority the implicit land cost subsidy). With the profit they could afford
to pay a high price for a better home. This has set off a stream of
homeownership upgrading that has proved highly profitable for developers,
decorators, brokers, bankers, retailers, lawyers, homeowners themselves, and
the government.
3. THE OPTIMAL POLICY

Public Housing vs the Market
A public housing program that sets out to satisfy the housing needs of
86 per cent of the population normally does not make much sense. But
Singapore obviously did a good job in its town planning and in meeting
citizens' housing needs. Notwithstanding the apparent success, however,
there is a price to be paid. Moreover, Singapore owes its success to
historical and particular reasons including the Central Provident Fund, a
forced savings program that became a backbone to the housing program. The
price is that there is little room for private developers to play in the
Singapore housing market, Singaporeans' choice of housing has become
rather limited, and taxes have to be much higher than otherwise.
Low Cost, Basic, but Decent Housing

In principle, a public housing program should aim at assisting the lowincome people. It should provide low-cost, basic, but decent housing only
to those who qualify and should disallow the richer people. from enjoying the
implicit subsidy. This restriction is both for justice reasons and for
efficiency reasons. The richer people normally would have opted for better
housing. Only very low rent would keep them in relatively low quality
housing because they place only a small value on living in such conditions.
Given the policy objectives of a public housing program, limiting implicit
housing subsidies to the target group is no doubt a correct policy. Unless
announced on the first day, however, such a policy will prove difficult to
157
implement, as Hong Kong's experience has shown. Hong Kong faced

considerable opposition from tenants and politicians when it tried to introduce a
"Housing Subsidy Policy" that would make the richer tenants pay more. For
too long Hong Kong had allowed full secure tenure to tenants once they had
been admitted into public housing. Against all these difficulties and in the face
of expected protests from tenants, however, the Housing Authority finally
managed to announce, in November 1986, that families who had lived in public
rental housing for ten years and whose income exceeded the prescribed would
start paying double rent as from April 1988.
"Conditional Bidding,,2
When the supply of public housing is larger than the number of target
group households, there will be a need to increase the supply of public housing.
But if the supply momentarily cannot meet the requirements of the target group,
it becomes necessary to ration the available supply among the eligible people.
One way of doing so is to use the first-come-first-served principle. The other
and a far better way is to allow the eligible households to bid among themselves:
whoever pays the highest price will get the unit-through either an outright
purchase or a rental arrangement. This can be called "conditional bidding"conditional in the sense that one's bid is conditional on one's being eligible.
The "conditional market" becomes segmented from the free market, as any
resale will also be restricted to the target group. The advantage of this
arrangement is that everyone within the target group can bid for any unit, which
will then find its "conditional market price." Each unit will go to the highest
bidder within the target group and all the target group players will not have to
wait. This means that each unit will realize its greatest valuation among the
entire eligible population. Any tenant or owner can vacate or sell his unit and
rent into or buy another unit from the conditional market.
The logic of excluding those outside the target group to bid is that given
that all those within the target group have similar abilities to pay, any household
who will not pay as much as others does so only because the unit is not as
valuable to him as it is to others. It is not because others have higher ability to
pay and on that account outbid him. Because the public housing program is
designed in the first place to assist the low-income people, there will never be
any leakage of housing units to outside the target group. The government will
then not need to commit so much resources to the public housing program.
In practice, once a household has moved into a public housing unit it is not
easy and certainly politically painful to ask him to leave. If a household is to
leave, he has to leave voluntarily. Given that this is the case, a policy of
making richer tenants pay higher rent, and enforcing the rule of resale only to
158
eligible households should do the trick. If richer tenants have to pay higher
rent, there will be little to gain in terms of rental savings for them to stay on. If
owners have to resell only to eligible households, there will be little hope of
reselling at a profit. Speculative holding of public housing units will be less
likely.
Maintaining the "Market Flow"

If public housing is basic and is restricted to households who are within
the target group, then those who have become better off will want to leave
the public housing units when they can afford it. The income elasticity of
demand for housing being positive and close to unity for high income
households, (O'Sullivan, 1996, p.389) better-off households will have a
great incentive to leave if the quality of housing is "basic."
Given that the units though decent are basic, the desire to realize a better life
will automatically lead many households who are ready for better housing to leave.
More of the eligible households will then benefit from the public housing stock.
At the same time there will be a stream of households entering the private market.
In order to facilitate this transition, Hong Kong's introduction, in 1978,
of "Home Ownership Scheme" housing that offered better quality housing
than rental public housing, is quite a good idea. The Home Ownership
Scheme housing in Hong Kong, however, is also subsidized. Accordingly
currently some eligibility criteria apply. As was pointed out, however, the
Hong Kong Housing Authority exempted existing public housing tenants
from the income eligibility criteria if they want to buy HOS housing, in the
hope that this will encourage them to vacate their subsidized rental units.
In principle, as long as the HOS housing is of better quality than the public
rental housing, and not quite as good as new private housing it will fmd buyers
only among the lower middle income people. There will be no need to
maintain eligibility criteria and HOS housing can be sold at full market prices.
These full market prices may still imply a subsidy, but this does not matter.
Such HOS housing will serve a purpose. It will enable more of the low cost
rental housing tenants and some of private housing tenants to buy a first time
home. With this kind of arrangement people should be free to sell and buy
HOS housing without restriction. 3 Because those who opt for better quality
have to buy in the private market, the market flow can be maintained. This
flow is very good for the economy, as it will generate a lot of jobs and sidebenefits throughout the economy. On the other hand, upgrading the quality of
rental public housing to approach that of HOS housing is a poor policy because
it will reduce the "flow" in the housing market. Tenants in rental public
housing will not move out. Turnover in the housing market will become lower.
159
4. CONCLUSIONS
The proposal of "conditional bidding" and segmenting the public housing
market from the private housing market may not find much favor among free
market economists. In particular, it may be felt that disallowing public housing
owners from selling their units in the open market is tantamount to not realizing
the full market value of these units. However, such segmentation is equitable
and efficient. It is equitable because the housing subsidy is intended only for
the target group. It is efficient because it minimizes the public resources
required to help to target group. As Chapter 18 points out, failing to segment
the market in an attempt to privatize public housing quickly can lead to
economically disastrous results.
Segmenting the low-cost housing market by spelling out that buyers of
subsidized public housing must not resell to people outside the target group will
reduce the opportunity for these owners to realize a capital gain. If this
condition is not in place, for every unit that is resold to people outside the target
group, the government will have to build a new unit in order to maintain the
same stock of low cost housing units for the low-income people. Clearly
segmenting the low-cost housing market this way will minimize the amount of
resources that the government has to devote to housing the poor. There will be
less pressure to raise taxes, and more of the poor people can be housed better
faster.
The Singaporean Housing and Development Board states its mission as:
"We provide affordable homes of high quality. We promote the building of
cornmunities." There is no right or wrong for the government body to take on
such responsibilities, but it does mean that with the government taking on such
policy missions, the private sector will have less room to play under such a
government philosophy, and taxes will have to be higher. If this is what the
community knowingly chooses, that would be fine.
In a system that prefers to allow the private sector to solve the
community's housing problems and to restrict the government's role to assisting
the poor, "homes of high quality" should never be built by the government.
The government should build decent but basic homes, so that when the poor
have become better off they will turn to private housing.
160
NOTES
1
2
3
See http://www.hdb.gov.sg/isoa034p.nsfifactsonhdbview?OpenView
The argument is given in greater detail in Ho (1988) and Ho (1995a).
The Hong Kong Housing Authority used to impose a lO-year period of residence before
an HOS owner can sell his unit in the open market. This rule has now been relaxed.
161
A DIGRESSION: TRANSPORTATION PRICING

Before closing this chapter, it is useful to refer to one key principle in
resource allocation, which is that prices should reflect (marginal) costs and the
pricing structure should also reflect the cost structure. Called the Efficient
Pricing Principle, it is fundamental to achieving efficient resource allocation. In
contrast, full cost pricing may be inconsistent with efficient resource allocation.
Marginal Cost Pricing and Optimal Departures from MC

Pricing
The Efficient Pricing Principle is best illustrated with transportation
pricing. In general, in a mass transit system, the marginal cost of providing a
passenger with a trip service is very low, and it does not vary much with respect
to the length of the trip. Given that the transit system is up and running, taking
an additional passenger, when there is not much congestion,l will have little
effect on total operation costs, implying that the marginal cost of a passenger trip
may be quite close to zero. This cost may also not vary significantly with the
length of the journey. The efficient pricing principle would suggest that the
fare would be rather low and would not vary much with respect to the length of
the journey. If this principle is not followed, and instead fares are fixed at such
levels as to attempt a full cost recovery in the name of the user pays principle,
chances are that, with the exception of very densely populated cities and very
heavily used routes, the system will be underutilized.
Following the efficient pricing principle to the letter, however, implies
that the government may have to subsidize the operation costs of the system
heavily. This in tum implies having to raise tax rates. Raising taxes,
however, is known to hurt economic efficiency. If the inefficiency caused
by having to raise taxes is even worse than the inefficiency of raising fares
above marginal costs, then it will not be wise to raise that much tax and it
will be wise to allow fares rise above marginal costs. This departure from
marginal cost pricing makes sense strictly on cost benefit principles. That
is, if a departure from marginal cost pricing produces more benefit (in terms
of allowing tax rates to stay low and thus avoiding "excess burden") than
costs (in terms ofunderutilization), then it should be allowed.
Because long distance passengers are more ready to accept higher fares
than short distance passengers, they are less likely to be driven away when
fares are raised above marginal cost. So raising fares for them may not
cause so much underutilization. For this reason it will make sense to
charge long distance travel at a higher rate than short distance travel.
162
Thus, in a second best world when taxes have to be raised to finance

the operations deficit in a mass transit system, the Efficient Pricing Principle
has to be modified.
Efficient Pricing Structure Principle

The Efficient Pricing Principle requires that the pricing structure follow
the cost structure. This is best illustrated with the pricing of taxi services.
There are actually several cost components in a taxi-passenger trip. First, there
is the cost of "booking" the driver and the taxi for the time of the trip. This
cost element strictly varies with the duration of the trip. Second, there is the
fuel and additional maintenance cost associated with the trip. This cost
element is closely related to the distance traveled. Finally, there is a
"passenger-pick-up cost", which is the cost of the taxi waiting in line, that of
cruising in the streets or the cost of going to the passenger pick-Up point in
response to a telephone call. This last element can be treated as roughly fixed
although there obviously is some random element to it.
In general, the fare structure does not reflect this cost structure and this
gives rise to problems. There are complaints against drivers discriminating
against short-trip passengers. Such discrimination occurs because normally
the fares do not reflect the fixed pick up cost. As a result taxis have to bear
the additional pick up cost for picking up another passenger.
Drivers are also wary about going into heavy traffic. When they are
caught in heavy traffic, even though there is often a "waiting time" charge
this charge may not even cover the cost of the time of the driver and the
rental cost of the taxi. As a result there are often arguments between the
driver and the passenger. Drivers may want to take a more roundabout
route to avoid the congestion, while passengers may object.
For all these reasons it makes sense to structure the charges to include three
elements: a fixed charge to reflect the pick-Up cost, a time-based charge to reflect
the rental or booking cost of the driver and the vehicle, and a distance-based
charge to reflect additional marginal costs that are related to the distance traveled.
NOTES
If there is congestion, so that taking on an extra passenger increases the waiting time
and discomfort for other passengers, the marginal cost will be very high reflecting the
time and discomfort cost. Fares should be correspondingly much higher.
Chapter 16
SOCIAL SAFETY NET AND REDISTRIBUTION
1. INTRODUCTION
Income distribution has traditionally been an important concern of
policy makers and policy analysts. Historically, extreme inequality in
income distribution has been cited as a major contributor of political and
social instability, and is considered by some to be one of the reasons for the
economic depression of the 1930s. However, from the humanitarian point
of view, it is far more important to have a social safety net than to have an
effective program of income redistribution. A social safety net will of
course have distributive consequences, but is not intended to be distributive.
Traditionally, people think of a social safety net as income support for
the needy. In particular, if someone is hit by some misfortune and is unable
to fend for himself because he is sick or disabled, the safety net will come to
his aid, and will reduce his suffering tremendously. A social safety net
transfers income, not so much because the recipient is poor but because he
has been hit by misfortune beyond his control. Income redistribution, on the
other hand, simply transfers income from the "have" to the "have not."
This chapter wants to advance one doubtlessly controversial idea,
which is that access to a basic job is a human right and an important social
safety net. These days an able-bodied person may have great difficulty
getting a basic job, which is defined as a job that offers an income that can
maintain the daily subsistence and satisfy the basic needs for social life.
Since what constitutes a basic pay is certainly subject to the subjective
judgment about what is subsistence and basic needs for social life, there is
little point in trying to be very precise about the dollar amount for the salary
of a basic job. However, both the idea of access to a basic job for the ablebodied and that of providing adequate income support for the disabled and
the physically disadvantaged are important elements of a respectable social
safety net.
164
2. ACCESS TO A BASIC JOB AND MINIMUM WAGES

The minimum wage was recently advanced as a redistributive tool
(Freeman, 1996). According to Freeman, "an appropriately set minimum
[wage] can be a modestly effective redistributive tool." (p. 640). The
effectiveness of the minimum wage would be particularly enhanced if the
social welfare system complements the minimum wage by enhancing inwork benefits (pp.644-645).
Freeman does recognize, however, that the minimum wage will
potentially reduce the availability of jobs (p.648). From a theoretical point
of view, if the minimum wage is set at a sufficiently high level, there is no
question that jobs will disappear. The current debate about the employment
effects of the minimum wage is whether a minimum wage set at a low level
will also adversely affect job availability.
David Card and Alan Krueger (1994) presented a case of minimum
wage increasing jobs. In that particular case, the minimum wage was
raised in one region (New Jersey) relative to that of a neighboring region
(Eastern Pennsylvania). Employment in the region with raised minimum
wages was found to increase. The reason behind this phenomenon,
however, may be that workers from other regions, particularly better workers
from other regions, are attracted to the region. Because of the increase in
productivity the demand for labor curve or the marginal product curve of
labor shifts to the right at the same time as labor supply increases. The
increase in employment in New Jersey may well be at the expense of
employment elsewhere. From this perspective, a nation-wide increase in
the minimum wage may reduce employment.
Economists usually find minimum wage legislation ineffective as a
means to improve the well-being of workers (Baumol and Blinder, 1991,
pp.773-774). First, it does not increase the incomes of those whose wages
are higher than the minimum wage. For those workers whose wages would
have been lower than the statutory minimum wages, only a few will be
employed at the minimum wages. The rest will be denied the opportunity
of employment altogether. In the industrial world, where minimum wage
legislation generally applies, the unemployment of unskilled, younger
workers who are supposed to be the major beneficiaries of the legislation, is
often serious. These groups are clearly hurt by the policy.
To ensure that the workers have a minimum income or living standard
without increasing unemployment we can use a wage subsidy. Unlike the
minimum wage, wage subsidies reduce the cost of hiring and increase jobs.
In principle, it is possible to bring wages up to the minimum level desired by
giving all workers a uniform and sufficiently large wage subsidy (equal to X
per cent of mean manufacturing wage), paid against hours worked up to
165
some standard number of hours, for example 35 hours.l If only the lowly
paid workers are given the wage subsidy employers would be encouraged to
reduce wages offered so as to "milk" the government. 2
It is useful to contrast such a universal wage subsidy (UWS) with the
negative income tax. The negative income tax (NIT) was first suggested by
Milton Friedman.
The NIT is like providing a universal taxable
"demogrant" to households?
This scheme has found favor among
economists. However, whereas the universal wage subsidy is conditional
on the employment status of those assisted, the negative income tax is totally
unconditional. The negative income tax provides a net positive income to
anyone so long as he is poor enough. Figure 1 illustrates how the universal
wage subsidy works
Figure 1. How the Universal Wage Subsidy is Financed.
Post subsidy Income
Pre-tax, Post Subsidy Income
45
Post-tax, post-subsidy
Income
Income below this Level Taxexempt
Pre-subsidy Income for 35

Hours of Work
Note: Work hours are assumed fixed and same for everyone.
while low income workers (A) gain.
Source: Ho (2000, p.95)
High income workers (B) lose
166
Like the minimum wage the universal wage subsidy can ensure an
effective minimum income for workers. Yet unlike the legal minimum
wage the universal wage subsidy does not set a floor to market wages and
will help create more job opportunities for workers. Unlike the Negative
Income Tax, which redistributes income from income-earning people to nonincome-earning people and has adverse incentive effects, the universal wage
subsidy increases low income peoples' incentive to work. It should be
recognized, however, that given the higher marginal tax rates imposed on
higher income people this increase in low income peoples' incentive to work
is achieved at the expense of higher income peoples' working incentives.
Indeed, as a result of universal wage subsidy employers of high wage
employees will need to pay more to hire workers (though workers receive
less in net terms because of higher taxes), while employers of low wage
employees will pay less (though workers receive more in net terms).
Some people may be concerned that a wage subsidy scheme opens up
opportunities for fraud. To implement the scheme the government needs to
have a record of the hours worked per month for each worker. Such
information has to be filed by the employer with the government in order for
the wage supplement to be paid. It may be objected that the employer may
collaborate with individuals who pretend to be working in order to share the
wage supplements. It may also be objected that the employer may reduce
the wage offered in view of the supplement.
With regard to the first objection, occasional random checking by
inspectors plus a stiff penalty should be sufficient to rule out large-scale
fraud. In any case, by mandating that a worker can claim for wage
subsidies only in one designated employment, we should be able to contain
this kind of fraud. With regard to the second objection, it should be noted
that employers have to compete for workers in the market place. The
uniform wage supplement will not give any one employer an edge over the
others. Competition will leave relative wages more or less intact, with the
result that low-income workers benefit.
In addition to the private sector jobs creation of which may be
increased by the universal wage subsidy it is wise for the public sector to
directly create "basic jobs" for job-seekers. The public sector jobs need
not be full time, so that holders of basic jobs will still have time to look for
alternative work. Providing basic employment for, say, three days a week,
to anyone who needs it will allow everyone to make a living and have
options other than unlawful ways of making ends meet. Actually there are
plenty of opportunities for productive work, partiCUlarly in environmental
and community-related work. If money is paid to the unemployed in the
form of welfare payments and to maintain prisons and crime fighting it is
certainly more productive and worthwhile spending the same money on
167
productive work. If jobs cannot be found you really cannot blame anyone for
stealing, defrauding, or even robbing in order to survive. Availing jobseekers of a basic job will contribute to a safer and more just society for all.
3. THE PHYSICALLY AND MENTALLY HANDICAPPED
AND THE OLD

It is recognized that many of the physically and mentally handicapped
can also work, if given a chance. They may need additional support though.
Subsidizing employers additionally for the hiring of handicapped people is
worthwhile. Using the argument from the chapter on justice, anyone of us
could be handicapped. The existence of a program in support of employers
offering jobs to the handicapped will certainly increase the chances of
obtaining work for these people. It will also alleviate the fear of all of us
for not being wanted in the labor market in the event of an accident leading
to a handicap.
Some of the physically and mentally handicapped may never be able to
work. Again using the argument from the chapter on justice, it is in
everybody's interest to offer them financial support and personal care.
Such care and support should be at a level which most people consider
adequate.
Many of the older workers also feel disadvantaged and experience
great difficulty finding jobs. The wage subsidy program and the basic job
program will help them find jobs, but some of the older people may not be
able to work. If there is a sound public pension system these elderly people
will have no worry about their daily living. In the absence of such a system
some of the elderly who have not saved enough for their retirement will need
an income transfer to meet their basic needs. In an affluent society their
needs cannot be ignored. But giving them a generous transfer will create a
moral hazard problem among the young, who may decide to enjoy life now
and not to save, expecting that when they grow old they will be cared for by
society. There is, therefore, a clear tradeoff between being humane to the
poor old and holding people responsible for their own retirement needs.
The society at large must decide for itself where it stands. Of course, to
avoid the dilemma it is best to have a sound public pension plan in the first
place.
168
4. UNEMPLOYMENT INSURANCE AS SAFETY NETS?

As Chapter 3 and Chapter 4 argue, all human beings are averse to big
risks, so that insurance against big risks is welfare-enhancing.
Unemployment insurance, in most cases, cannot be said to be an insurance
against big risks. Indeed, for most people unemployment is a temporary
phenomenon. The hardship would be over before too long and any
financial difficulties are mostly temporary. For this reason there is no need
for unemployment insurance as practiced in most western societies. What
may be needed is the availability of unemployment loans that can be
extended to the unemployed if needed. Such loans should be of a limited
amount and are intended to allow the unemployed to meet the basic needs of
food and lodging. They should be repayable as soon as the worker finds
normal work. This way, the disincentive for work will be eliminated. The
kind of unemployment insurance that we know requires a payroll tax on the
employed, which clearly reduces the incentive to work. The stipend paid to
the unemployed also tends to prolong the duration of unemployment. 4
While it is true that unemployment can be productive if the time is spent on
trying to find the better job, requiring the unemployed to balance the
potential benefits of the job search against the costs of job search is
economically efficient and need not compromise basic premises of justice.
The availability of a "basic job" on demand provides a further assurance that
the unemployed will not face excessive hardship.
5. REDISTRIBUTION IN KIND OR IN CASH, IMPLICIT
OR EXPLICIT
Clearly, safety nets have redistribution implications. However, they
are not and should not be the only redistribution mechanisms. In general
redistributive policies can be through the revenue side or the expenditure
side of fiscal policy. On the revenue side, there can be a transfer through a
tax-transfer system of income from the richer to the poorer. Most countries
have a progressive income tax system which, together with basic exemptions
and welfare payments, can have very significant redistribution effects. On
the expenditure side, various expenditures on health, education, public
transit, and particularly public housing, also redistribute real income in favor
of the poor. There is no inherently right or inherently wrong with income
redistribution, which can be Pareto-improving if socially desired (Hochman
and Rodgers, 1969). It is important, however, that the redistribution is
transparent and is deliberately executed through a public choice process,
169
with people participating in the deliberation process alerted to the

consequences of the redistributive measures.
It is well known that the American public pension system has
redistributive features. While benefits are bigger for those who make bigger
contributions on account of their incomes, benefits are not directly proportional
to contributions. The implicit redistribution, however, is not transparent and
cannot be easily calculated. On the other hand, the fully funded public pension
plan that I proposed in Chapter 8 provides that people of the same cohort make
the same contribution and receive the same benefits-with the exception that
those who are classified as poor will have their contributions subsidized. This
arrangement makes redistribution transparent.
Although it is highly desirable that a policy aimed at redistribution is
best executed through the tax-transfer system, some redistribution will work
through the expenditure side of the budget. This is because there are
policies which are valued for purposes other than redistribution but which
have redistribution implications. Education, health care, and housing are
primary examples. Education, health care, and housing clearly have effects
beyond those who enjoy the services. Expenditures on these items
predominate in most government budgets all over the globe. Redistribution
effects are significant but are incidental to the design of these policies.
Because of the significant redistribution effects involved, however,
redistributive policies must take full recognition of the effects of these
policies. Otherwise there will be more redistribution than is warranted.
6. CONCLUSIONS
Distribution matters have always been given an important place in
public economics and social policy analysts. Musgrave in his 1959 Theory
of Public Finance treated distribution as one of three main responsibilities of
the "Fiscal Department," along with allocation and stabilization. (Musgrave,
1959, p.5) Even today, social scientists regularly come up with fresh policy
proposals addressed specifically to redistribution concerns. Following the
Negative Income Tax Proposal (Friedman, 1962, 191-194), Phelps came up
with alternative wage subsidy proposals to help the working poor (1994,
1997), Fitzpatrick (1999) gave a round-up of the debate on the idea of Basic
Income Guarantee.
There is an obvious distinction between the Negative Income Tax and
Basic Income Guarantee on the one hand, and targeted or universal wage
subsidies on the other hand. The former are not conditional on work and
will have adverse work incentives.
The latter are conditional on
employment and will have positive work incentives. Rather than a Basic
170
Income Guarantee, I propose a basic job guarantee and a universal wage

subsidy. These measures will help reduce the unemployment rate, will
provide alternatives to crime, and will make our streets and our homes safer.
With expected declines in crimes and higher employment, savings generated
from reduced prison and police costs, reduced welfare payments, and
increased taxes will allow the government to finance the program. In
addition, safety net provisions in the form of income transfers targeted at
those hit by misfortunes such as physical or mental disabilities will make the
society more humane, more just, and more efficient.
NOTES
2
3
4
The following material is largely drawn from Ho (1999). A similar proposal,

unknown to the author at the time, was made by Jackman and Layard (1986).
Phelps (1997) discussed ingenious ways of overcoming this problem, but they may be
bogged down by heavy administrative costs.
In some versions the demogrants can be means-tested. For an introduction see
Fischer, Dornbusch, and Schmalensee (1988).
Ljungqvist (1999) concluded that reducing unemployment benefits or imposing work
requirements would be necessary if unemployment in Europe was to be reduced.
Christofides and McKenna (1996) found evidence, using Canadian longitudinal data,
that a significant number of jobs terminate when the duration of employment have
gone past the qualifying requirement for a unemployment insurance claim.
Part 5
PUBLIC POLICY AND ECONOMIC ECOLOGY
The two chapters in this section make the point that the economy is like
an ecological system. It contains many different sectors and sub-sectors,
and they all depend on one another and hang together in a delicate
"ecological balance." In general we can say that the economy consists of a
public sector, a business sector, a household sector, and an external sector.
Of these four sectors the public sector figures dominantly. Public policy is
not something to play with. It has big impact on the economic system.
Chapter 17 shows that macroeconomic policy can cause serious problems.
Indeed, the Great Depression of the 1930s was the direct result of misguided
macroeconomic policy that sets out to curb the excesses of speculation and
mishandling of events that unfolded. Chapter 18 shows that a misguided
micro economic policy, one that appears to impact only on a sub-sector
within the economy, can also produce gigantic economic losses. The two
chapters attest to the wisdom of the Chinese adage that when we do not
know, we had better grope the stones underneath carefully as we wade
across the river.
Chapter 17
ECONOMIC ECOLOGY: THE CASE OF THE
GREAT DEPRESSION OF THE NINETEEN
THIRTIES
Ours is a land rich in resources; stimulating in its glorious beauty;

filled with millions of happy homes; blessed with comfort and opportunity.
In no nation are the institutions of progress more advanced. In no nation
are the fruits of accomplishment more secure. In no nation is the
government more worthy of respect. No country is more loved by its people.
I have an abiding faith in their capacity, integrity and high purpose. I have
no fears for the future of our country. It is bright with hope.
President Hoover, Inaugural Address
March 4,1929
There is a story we wanted to tell. It is the tale of powerful, wellintentioned people in several countries who committed an incredible
sequence of policy errors that generated a cataclysmic event reaching
around the entire globe. The disasters of the 1930s were not caused by
some uncontrollable event such as the eruption of Mt. Vesuvius that buried
Pompei. Instead the Depression was caused by people with good intentions
carrying out misguided economic policies that they thought were proper, but
that actually created an absolute disaster.
Hall and Ferguson (1998),from the Preface
1. INTRODUCTION
Many historians believe that the Great Depression of the nineteen
thirties was a direct result of the excesses of the "roaring twenties." The
Great Depression was routinely blamed on excessive speculation and greed,
and increasing inequality in income distribution, as a result of which the
masses did not have the necessary purchasing power to sustain the humming
174
production machinery of the United States. As a matter of fact, however,

the 1920s was a time of true prosperity and solid economic growth. The
solid economic growth was achieved with almost no inflation, and was
brought about by major breakthroughs in technology that raised productivity
tremendously. The US Federal Government ran a budget surplus for every
year from 1920 to 1930 inclusive. With support from Hoover as Secretary
of Commerce and a healthy dose of export credit extended from overseas
branches of US banks, American exports rose from $3.8 billion in 1922 to
$5.2 billion in 1929, while imports lagged behind, resulting in trade
surpluses which reached $800 million by 1929. The United States had
already emerged as a creditor nation after the First World War, and had
continued to accumulate net claims against the rest of the world through
aggressive investment abroad. Indeed, the rest of the world had become so
dependent on the loans from America that one standard American history
text observed:
"Should American loans abroad cease, disastrous
consequences would be inevitable." (Barck Jr. and Blake, 1974, p.287)
It is certainly true that stock prices had soared to unprecedented levels.
But does this necessarily imply excessive speculation? While some are
convinced that the stock market on the eve of the crash was a bubble others
find the case not closed. Sirkin (1975) and Bierman (1991) argued that the
stock prices in 1929 were consistent with the economic fundamentals.
Based on data on the 29 profitable firms out of the 30 used to compute the
Dow Jones Industrial Average, Sirkin found that the mean price-earnings
ratio in September 1929 was 21.6 while the median was 15.1. To maintain
such ratios for another 5 years, earnings only needed to rise at the same pace
as that between 1925 and 1929, which would not seem to be an unrealistic
assumption at all.
Just as with any crisis, including in particular the Asian Financial Crisis
of 1997-98, one could find many things wrong and could attribute the crisis
all to all these factors. It is the purpose of this chapter to argue that the
"excesses" notwithstanding, the Great Depression came not because it was
"payback time," but because of silly policy mistakes. Policy mistakes cost
over a decade of economic growth.
Economic Ecology: The Case o/the Great Depression o/the Nineteen Thirties
175
2. THE ROARING TWENTIES

Table 1.
Annual Macroeconomic Data 1921-1941 {Eer cent}

Labor
Real MI
S&P
GDP
Real GDP Unemploy- Ml%
Deflator
Productivity
Index
Growth ment Rate Change % Change
Growth
Inflation
%Change
1921
-12.8
-3.5
11.7
1922
-7.0
7.2
6.7
1923
2.5
14.0
2.4
1924
0.0
2.7
5
1925
1.6
2.2
3.2
1926
0.8
6.0
1.8
1927
-1.6
0.6
3.3
1928
-0.8
1.8
4.2
1929
0.0
6.4
3.2
1930
-3.3
-9.4
8.9
1931
-8.4
-8.5
16.3
1932
-11.0
-13.4
24.1
1933
-3.1
-2.1
25.2
1934
9.6
7.7
22
1935
8.1
20.3
2.9
1936
14.1
17
0.0
1937
3.8
5.0
14.3
1938
-1.8
-4.5
19.1
1939
-0.9
7.9
17.2
1940
1.9
7.9
14.6
1941
6.4
17.7
9.9
Source: Robert Gordon: Macroeconomics, 6th
-13.3
3.8
8.5
20.8
3.1
2.3
5.6
3.6
23.4
6.5
12.1
1.2
17.7
1.2
2.0
26.8
27.3
0.8
-21.5
0.2
2.2
-37.1
-48.4
-1.9
30.2
-2.8
14.6
0.7
14.9
8.5
41.2
13.8
0.0
1.0
-25.0
0.5
-1.3
7.4
13.1
12.1
-6.9
14.0
16.2
-9.3
17.0
9.9
Edition, Harper Collins, 1993.
-9.5
1.0
5.7
3.6
8.2
2.0
-0.4
1.2
0.8
-3.1
-6.3
-12.7
-5.8
10.3
18.2
13.8
4.9
7.0
0.0
5.5
4.9
-1.2
2.5
1.2
0.9
4.5
-2.9
-0.3
-2.1
-1.2
9.5
2.5
6.3
-1.3
4.7
2.5
3.4
8.0
Table I shows that starting from 1922, the US economy was on a healthy
growth track. Except in 1925 when there was a slight decline, labor
productivity was rising at a healthy pace. The real GDP grew rapidly in 1922
and 1923, took a breather in 1924 and 1925 before picking up again in 1926.
In 1929 the economy was growing very rapidly, but only after two rather slow
years in 1927 and 1928, when the unemployment rate rose to 4.2 per cent.
There was no inflation and no sign of overheating. While the stock market
was booming, annual rates of growth between 2 and 27 per cent during a time
of expanding profits, productivity growth, and rapidly accumulating savings
cannot be said to be grossly excessive. It should be noted that during this
decade of economic boom the private sector was running a "surplus" which is
reflected in a favorable trade balance and increasing net investment abroad.
176
At the same time the government had also been running a budget surplus for
every year since 1920.
Many economic historians picked on the rising income inequality to be a
key contributory factor to the Great Depression. Over the period from 1922 to
1929, the share of income accruing to the top 1 per cent of income earners rose
from 12 per cent to l3.7 per cent. The share of wealth owned by the top 1 per
cent of adults rose from 32 per cent to 38 per cent. Even more dramatic is the
fact that, in 1929, the top 1 per cent of income recipients accounted for 80 per
cent of total savings in the country, up from 49 per cent in 1922 (Hall and
Ferguson, 1998, p.21). It was believed that such a concentration of wealth and
income meant that total consumption would not be adequate to maintain full
employment.
In point of fact, the roaring twenties generated jobs and higher living
standards for the great majority of Americans, though some sectors, particularly
agriculture and coal mining, were left in the limbo. But it was a time of great
technological change, and the most gains were achieved by a small minority
who could take advantage of the new opportunities. At the time, investing in
common stock was rather uncommon. Galbraith (1954) estimated that only 1
per cent of the US popUlation participated in stock market investment. This
might lead us to think that the stock market crash of 1929 should not have
caused excessive damage on the economy. It is important, however, to
understand the dynamics involved in the stock market advance and set off in
the stock market decline.
The economy revived rapidly in 1922-23 after the post World War I
recession. New industries, particularly the chemical industry, the automobile
industry, and the steel industry, developed rapidly. Because of a boom in
construction, other industries like steel, cement, lumber, electrical appliances,
plumbing, and heating equipment benefited. The profits generated in these
industries benefited the stocks of the companies, and investing in stocks was
the best investment. From 1922 to 1929, not a single year turned in a loss for
stockowners. Stocks were the best collateral for loans. These loans financed
real investment as well as more stock purchases. Margin loans were common,
and banks were happy to extend loans to brokers who in tum were happy to
extend to investors. Obviously, if the stock prices turned unfavorable, lenders
would exercise their call for repayment to keep the loans in good standing
against the shrunken collateral. The investors would get hurt but this would
not be a big thing for the economy, because it was not a systemic problem.
Brokers acquired a total of $7.63 billion in loans in 1924 from banks and nonfinancial corporations for re-lending to investors in the form of margin loans.
This rose to $26.53 billion by 1929 (Hall and Ferguson, p.24). Galbraith
(1954), who subscribed to the thesis that excessive speculation was at fault,
pointed to the fact that the interest rate on margin loans was 8.56 per cent while
Economic Ecology: The Case ofthe Great Depression ofthe Nineteen Thirties
177
the dividend yield on stocks in September 1929 was 2.92 per cent. But such
interest rate spreads are quite common anywhere and should not in itself
suggest any imminent disaster.
To put things in perspective, America's economic achievement during the
roaring twenties was most remarkable. Office towers were erected, extensive
roads and bridges were built, new industries took root. Annual production of
motor cars rose from 1.9 million in 1920 to almost 4.8 million in 1929.
Notwithstanding the big investments throughout the twenties, the United States
accumulated claims against the rest of the world, as the following table, taken
from Shannon (1974, p.90), shows:
July 1 1914
December 31 1919
July 1 1929
Private Credits:
Securities
Direct Investments
Short-term Credits
Private Debits:
Securities
Direct Investments
Seized Enemy Property
Short-term Credits
Net Private Debit or Credit
Intergovernmental Debt:
Owed to United States
Owed by United States
Total Net Debit or Credit
862
2652
2576
3880
500
7839
7553
1617
5440
1310
450
-3686
1623
900
662
800
2971
4304
1400
150
3077
8078
11685
-3686
9982
391
+12562
+19763
If the American economy was so strong and the savings so concentrated,

those who participated in the stock market must be the richest few in the
country. Galbraith (1954) estimated that only 1 per cent of the population
participated in the stock market. These were the people with the best credit
standing and were usually high income earners. They had been putting their
savings, as well as borrowed money, into the stock market, in overseas debt
instruments. On the surface, the stock market crash should hurt only a tiny
minority of the American population. The story of the Great Depression tells
us, however, that if the fortunes of these wealthy, powerful people are
systematically ruined, I the whole economy may suffer, because so many things
depend on them.
The magnitude of the crisis that ensued after the stock market crash of
1929 took many experts by surprise. Shannon (1974, p. 154) cited the
inadequacy of economic insight among the supposedly best minds. "Even
after the crash, the economists remained optimistically reassuring.
In
178
November, 1929, the Harvard Economic Society declared that "a serious
depression .. .is outside the range of probability." Even Irving Fisher in 1930
wrote that the "outlook is bright." The truth is that these "foggy prophets"
erred not on their assessment of the economic fundamentals. Perhaps Fisher
should have said, "The fundamentals of the economy are sound but are highly
sensitive to policies. If the policy makers do the right things the outlook is
bright. Otherwise the economy can go awry."
3. THE CRASH
As things turned out, the Federal Reserve began to worry about excessive
speculation in 1928, and started to raise interest rates and tighten credit at a
time that actually begs for looser money. Although money supply figures
appeared to be rather neutral they were highly misleading. Statistics suggest
that the money supply growth had provided the impetus for the stock market to
rise to dangerous levels. Just as Adam Smith feared, high interest rates
inhibited entrepreneurs but may not inhibit speculators (p.379). It was this
tightening that resulted in a sudden reversal of economic fortunes for many
private businesses, culminating in the stock market crash of October 1929 and
the Great Depression.
Consumption spending had slipped badly in 1929 well before the Crash.
Residential construction, which had been falling since 1925, declined markedly
in 1928. Farmers had been hurting throughout the decade from falling world
prices and heavy indebtedness (Walton and Rockoff, 1998, 518-519). There
was deflation, not inflation. There was little sign that the economy was
overheated. The economy should have needed some stimulation, certainly not
contraction.
Yet, from the beginning of 1928 to May 1929 an unprecedented monetary
tightening took place. The Federal Reserve sold $405 million worth of
government securities, raised the discount rate three times from 3.5 per cent to
5.0 per cent, raised the buying rate on bankers' acceptances, and persuaded
member banks from making loans to finance speculative activities. The
restrictive effects of these measures on the money supply, however, were to a
large extent offset by member bank borrowing from the Federal Reserve,
because while the discount rate had been raised money market interest rates had
gone up much more, making it profitable to borrow from the central bank and
lend it out. From what we know, however, although the money supply did not
fall noticeably a significant fraction of the money supply facilitated stock
market transactions rather than transactions in the real economy. The stock
market continued rising, with high volume, well through September 1929. At
Economic Ecology: The Case ofthe Great Depression of the Nineteen Thirties
179
the same time, the higher interest rates hit home at the real economy and
aggravated an ongoing economic slowing down that had already taken hold.
"The combination of tight credit conditions and the recession moved the
New York Times Index of industrial stocks to 403 on October 24 (from a peak
of 453 reached in September) (Black Thursday). The panic occurred on
Monday and Tuesday, October 28 and 29, when prices fell by a total of 23 per
cent." (Hall and Ferguson, p.66) By November 13, the trough for 1929, the
index had fallen about 50 per cent from its peak in September.
Because of the high concentration of stocks in only 1 per cent of the
American population, superficially the direct impact of the stock market crash
on consumption should be relatively small. However, because of the high
leverage usually associated with stock holdings, the balance sheets of the
wealthiest few deteriorated dramatically. To the extent that many firms were
holding part of their surpluses in the form of stocks and had loaned their
surpluses to stockbrokers the balance sheets of these firms had an about-face.
The urge to self-protect led to further "dumping" in the stock market. The
resulting price declines generated more fear and further rounds of dumping.
Bankruptcies fed into more bankruptcies, while bad inter-firm loans and bad
credit snowballed. During these times despite interest rate hikes the actual
level of nominal interest rates in 1930 were not particularly high,z but banks
had reasons to worry about their own survival. So few would lend to
businesses to help them through the hard times. Within the business sector,
the ability to invest, as much as the confidence to invest, was hard hit.
Investment in real terms fell 23.4 per cent, 31.7 per cent, and 42.0 per cent
respectively in 1930, 1931, and 1932. Mirroring such dramatic declines in
business fixed investment was the surge in unemployment, which jumped to
8.9 per cent in 1930 (from 3.2 per cent in 1929), jumped further to 16.3 per cent
in 1931, and peaked at over 25 per cent in 1933.
Setbacks in the stock market and in the real economy led to waves of
bank failures. 3 Particularly in October 1931, after a series of bank failures in
the South and Midwest, there was widespread panic. More bank runs
followed. While many of the banks besieged by depositors trying to get their
money back were solvent but illiquid, the Federal Reserve failed to come to the
aid of these banks, believing that allowing banks to fail would condone
inefficiency. During a time of uncertainty, this was a serious mistake.
According to Bemanke (1983), borrowers who used to borrow from a bank that
had failed were completely new to other banks. It is difficult for these other
banks to assess the credit standing of these new borrowers. To play safe they
simply would not lend. As a result, many firms, particularly the smaller ones,
could not get the credit needed to stay in operation.
Because of deflation, which intensified in 1931 and especially in 1932
debt-ridden companies had a rough time servicing and repaying their debt.
180
Here again we see the important value of indexing bonds against inflation.
The borrower's real borrowing costs should not be at the mercy of price level
changes. If businesses which had issued bonds could adjust their interest
payments and repayments down with deflation, many of those firms that had
failed would have survived. Unemployment and investment would have been
higher, and with that consumption would also have been higher. The
recession would not have been so serious.
4. THE BRITISH POUND WENT OFF THE GOLD

STANDARD IN 1931: EXPANSIONARY MONETARY
POLICY WORKED
During the twenties the United States had been running trade surpluses
year in, year out. Under the gold standard, the United States' increased
accumulation of gold reserves should have led to an expansion of the money
supply and thus should have caused prices to increase. However, while
American monetary reserves were rising on account of the trade surpluses, the
Federal Reserve Board was selling US government bonds and thus reducing
monetary reserves. Through such sterilization US incomes and prices would
not rise as would under a classical specie-flow-price mechanism. With the
British pound overvalued and the gold flows failing to cause a relative price
adjustment between the US and the UK, the United Kingdom had to endure
ongoing high unemployment rates of about 8 to 9 per cent during the period
1925-29. The problem was exacerbated in 1930-31, as the ongoing outflow of
gold led to a selling of the British pound. Trying desperately to defend the
pound without raising interest rates which would worsen the already very high
unemployment rate further Britain tried to borrow money from the US and
from France. But the borrowed amounts were far too small to stem the flight
from the pound, which eventually went off the gold standard on September 21,
1931. By December the pound sterling lost 30 per cent of its value. While
the Treasury wanted interest rate cuts, however, because of objection from the
Bank of England this had to wait until February 1932. More cuts followed in
the year, and the British economy rebounded quickly. According to
Kindleberger (1986, p.240) the UK was the first economy to surpass the 1929
industrial production level. As early as the last quarter of 1934 the index of
industrial production had reached 116, up from 114 in the last quarter of 1929.
Economic Ecology: The Case ofthe Great Depression ofthe Nineteen Thirties
181
5. CONCLUSIONS
There is still controversy over the cause of the Great Depression. People
could debate over the role of the Smoot-Hawley Tariff Act of 1930, which by
raising US imposition on imports to over 50 per cent started a tariff war against
the US and ended up hurting US production. People could argue over
whether the crash of 1929 was a natural outcome of the "excesses" of the
earlier years, and whether it was largely a result of the Federal Reserve's
engineering. Two things, however, are clear.
First is that tight money has a lot to do with the Great Depression. Tight
money was intended to stem excessive speculation. In the end it succeeded,
but the effects of the resulting Crash and the tight money were mostly in the
real economy. Quite apart from the psychological effect of the Crash on
investor confidence, the Crash hurt the ability to invest. Because stocks had
served as collaterals for loans a large decline in stock prices means a de facto
tightening of credit. Corporations with surplus cash lent to brokers suffered
big losses as defaults mounted. Former net asset positions quickly turned into
net liability positions. Personal and business bankruptcies followed. Other
firms and persons were affected. Tight money in Germany in 1928, intended
to stem a capital outflow, had caused in full-blown recession by mid 1929.
Tight money in the U.S. in the same year when the economy was slowing
down rapidly was badly timed.
The second is that when deflation set in all firms that had issued debt
were in deep trouble. Deflation means falling incomes. Servicing cost and
repayment costs, however, stay put when the debt instruments are not indexed
against price movements. As deflation was a general phenomenon and debt
issues were also common, the effects on the economy were very serious. The
tragic note to this is that this problem could easily have been avoided, if the
debt instruments issued had been indexed against price movements, as many
economists from Keynes to Friedman have urged.
After the Crash had happened and the Great Depression had begun, it is
easy for people to talk about the earlier "excesses." But on the eve of the
Crash, American corporations had strong balance sheets, the federal
government had a strong fiscal position, and most American households had
enjoyed an unprecedented increase in earnings that was built on strong
productivity growth and technological advance.
Inflation was low.
Unemployment was moderate. What kind of excesses are we talking about?
Stock price increases of up to 30 per cent a year? Consumer credit and the "buy
now, pay later" culture? Buying stocks and homes with margin or mortgage
loans? The subtitle of Hall and Ferguson's book is apt: "an international
disaster of perverse economic policies." Yes, leveraged investments are risky.
Income and wealth distribution was highly skewed. Expectations were too
182
high. But to argue on the basis of all this that the great crash was implicit in
the stock price increases is not convincing. Irving Fisher was reputed to have
remarked, shortly before the crash, that "stock prices have reached what looks
like a permanently high plateau" and that "anything in the nature of a crash"
was not in sight." (Walton and Rockoff, 1998, p. 512) From what we can
gather, although the economy was slowing down, the economic fundamentals
of the American economy in 1929 were basically sound. Instead of stimulation
that was needed the Federal Reserve gave the economy a heavy dose of
monetary restriction. It did not realize that the economic system is like an
ecological system. Different elements hang together closely and depend on
one another.
Policy makers may not like the leveraged purchase of stocks and homes.
But if the leveraging is already a fact of life you cannot simply undo it
overnight. Given the institutional framework and the economic conditions,
even without intervention stock prices would come to an equilibrium (the kind
of price plateau that Irving Fisher was talking about) and, if there was excessive
speCUlation, would fall back to a level befitting the economic reality. The fact
that the economy was already slowing down and that profits were already
declining would have limited further increases even without central bank
intervention. Raising interest rates would only accelerate and amplify stock
price declines. Since investment in stocks were highly leveraged, such price
declines quickly led to more declines, as brokers had to sell off the stocks of
those investors who could not come up with the needed cash to meet margin
requirements. Since many firms directly or indirectly had positions in the
stock market, the crash hurt their balance sheets and prevented them from
investing. Sharp declines in investment led to unemployment and reduced
consumption. Well-intended policies that set out to stabilize things turned out
causing the greatest instability of all time.
NOTES
2
3
This is in contrast to individual tycoons losing their fortunes, which should not have
serious repercussions.
Real interest rates, however, had begun to be painfully high in 1930.
According to Hall and Ferguson (1998, p. 83), the failure of the Federal Reserve to
come to the aid of banks hit by runs in October 1930 using the criterion of the real bills
doctrine, sowed the seeds of disaster by shaking confidence in the U.S. banking
system.
Chapter 18
ECONOMIC ECOLOGY: THE CASE OF HONG
KONG
1. INTRODUCTION
This chapter seeks to find an explanation for the Hong Kong
economy's unprecedented plunge into deep recession in the wake of the
Asian Financial Crisis. Hong Kong had gone through so many ups and
downs through its history, and until 1998 not a single year since 1961 was
there recorded negative economic growth (See Table 1). Among the crises
that Hong Kong had gone through are: the Great Proletariat Cultural
Revolution in 1966 through 1968;1 the two major oil crises of the seventies;
the plunge of the Heng Seng Index from over 1700 in 1973 to less than 200
in 1975; the unprecedented interest rate hikes of 1981-82, when the prime
rate momentarily shot up to 20 per cent; the Tiananmen incident of 1989, etc.
Hong Kong had gone through true financial and banking crises, in the early
60s and from 1982 through 1986, with multiple bank failures, and it was in
the context of widespread panic and currency depreciation that the current
linked exchange rate system was set up in 1983. But Hong Kong's growth
engine never failed, until 1998.
Table 1. Hong Kong's Economic Growth 1961-1999 (GDP % change)
1961
n.a.
1981
9.2
1971
7.1
1962
14.2
1972
10.3
1982
2.7
1963
15.7
1973
12.4
1983
5.7
1964
8.6
1974
1984
10.0
2.3
1965
14.5
1975
0.4
0.3
1985
1966
1.7
1976
10.8
16.2
1986
1967
1.7
1977
11.7
1987
13.0
1968
3.3
1978
8.0
8.5
1988
1969
11.3
1979
2.6
11.5
1989
1970
9.2
1980
10.1
1990
3.4
Source: Gross Domestic Product 1961-1999, Government ofHKSAR
1991
1992
1993
1994
1995
1996
1997
1998
1999
5.1
6.3
6.1
5.4
3.9
4.5
5.0
-5.3
3.1
184
It is true that the Asian Financial Crisis of 1997 was a serious one and
had plunged many otherwise economies into deep recession.
But given
Hong Kong's tight links with China and the United States, both of which
registered strong growth in 1998, and Singapore's tight links with the
ASEAN countries, all of which had been directly or indirectly affected by
the Asian Financial Crisis, Hong Kong should have fared better than
Singapore. Yet Singapore's economy in 1998 registered a 1.3 per cent
Hong
growth, as compared with Hong Kong's negative 5.3 per cent.
Kong should in any case be in much better shape than debt-ridden South
Korea. But by the second half of 1999 South Korea had rebounded to well
over the pre-crisis level. Having declined by 5.8 per cent in 1998, the
South Korea economy bounced back by 10 per cent in 1999. In contrast,
Hong Kong's economy shrank by 5.3 per cent in 1998, and grew by a mere
3.1 per cent in 1999.
Hong Kong's trade figures started to improve markedly in 1999 and by
the first quarter of 2000 Hong Kong appears to be well on its way to
recovery, with a 14 per cent year-on-year growth. But the strength of the
external sector had scarcely benefited domestic consumption through late
1999. Most of Hong Kong people continued to feel the crunch of the
recession.
To understand the predicament of Hong Kong people we have to
understand the cause behind the unprecedented recession that hit Hong Kong
so suddenly. What really caused such dramatic changes in the first quarter
of 1998 when the economy lost 12.0 per cent of its GDP?2 One could
easily blame the currency turmoil in South East Asia spilling over to Hong
Kong, but this is really not convincing. As a matter of fact, in the first
quarter of 1998 there was one interest rate drop, and the currency turmoil
had shown signs of stabilizing. There was even a brief period of property
price increase in March, following the interest rate decline and the
announcement of a stimulative budget. To put things in perspective, Hong
Kong's economic performance in the first quarter of 1998 was worse than
that of Malaysia, and much worse than that of Singapore or Taiwan. A
transmission mechanism whereby major declines in the values of the
Indonesian rupiah and the Thai baht caused the property bubble to burst and
the Hong Kong economy to lose its characteristic vigor and legendary
resilience is simply lacking.
My simple hypothesis is this. The economic decline was the direct
and immediate result of misguided housing policy, particularly its drive to
increase ownership in the property market. The Chief Executive in his first
Policy Address of October 1997 explicitly called for increasing the
homeownership ratio from 50 per cent to 70 per cent in ten years, and tried
to achieve it through an ambitious yet flawed public housing privatization
Economic Ecology: The Case ofHong Kong
185
program. The recession was a result of the working of "economic

ecology," as a misguided microeconomic policy worked through the
economic system to produce a gigantic macroeconomic disaster.
2. THE BASIC AND NON-BASIC SECTORS AND THE

RICHER-P AYS-MORE "HOUSING SUBSIDY POLICY"
OF APRIL 1987
In the eighties the Hong Kong economy took advantage of the opening
up of the Chinese economy and started moving the bulk of manufacturing
processes into China, particularly the Pearl River Delta.
Superficially
there is a "hollowing out" of the economy. But despite the hollowing out
the economy was marching along quite well, on the basis of what some
commentators called the "virtual economy."
Indeed, borrowing the
terminology from regional economics, Hong Kong's external sector, the socalled "basic sector," has suffered only a temporary setback during the Asian
Financial Crisis. This sector includes the export of goods and services, and
earnings from investment overseas, and offshore trade.
Hong Kong is the
brain center directing so much happenings in the region and around the
world. Yet not everyone works in the basic sector. For each individual
who works in the basic sector, perhaps four or five people work in the nonbasic sector. The non-basic sector, i.e., the sector that depends on the
domestic market, draws its strength from the basic sector and depends on the
basic sector for its survival.
In order for more people to share the material benefits achieved in the
basic sector, the economy needs a mechanism to transmit the economic
benefits to the rest of the economy. The property market provides such a
mechanism. In particular, when people get richer, they tend to move to
bigger houses, and in so doing benefiting real estate agents, banks, lawyers,
retailers, decorators and interior designers, furniture makers, insurance
agencies, restaurants, etc. It is on the basis of a very strong basic sector
that Hong Kong had enjoyed its property market boom for decades.
The rather spectacular property market boom from 1987 to 1997 that
Hong Kong enjoyed, however, is not only a result of strength in the basic
sector. One key factor that is unique to Hong Kong is the implementation
of a new public housing policy. The so-called "Housing Subsidy Policy,"
first introduced in April 1987, expressly sets out to reduce the implicit
subsidy to the richer tenants in public housing estates by making them pay
higher rent. Although the spirit of the policy was clear at the outset it had
been refined a few times. In essence, the policy requires those tenants who
186
have been accommodated for over ten years and who have a household
income three times that of the maximum eligibility limit to pay double rent,
while those who have breached stipulated income and asset thresholds are
required to pay market rent. 3
Such a policy alerted the complacent public housing tenants that they
could not take low rent for granted. Given that they had enjoyed long
periods of very low rent amidst high inflation, they had accumulated
considerable savings, which were ready to be tapped on to buy properties.
In a survey conducted by the Housing Authority in 1993, some 24 per cent
of all home purchases in the market place were traceable to public housing
tenants. Since public housing tenants are supposed to be poor people
hardly able to pay market rent this figure is quite disturbing but at the same
time it shows that the Housing Subsidy Policy is right.
The continual pouring of money from the richer public housing tenants
into the market buoyed up home prices. First Home Ownership Scheme
Housing (a low cost homeownership program administered by the Housing
Authority) owners found that they could sell their homes at a handsome
profit. Such handsome profit allowed them to place an attractive bid for the
next higher category of homes. The owners of the latter, in turn, being able
to sell at a high price, are also able to pay a higher price for better still
housing. The effect goes on. Figure 1 shows that property prices rose
spectacularly from 1987 through 1997.
3. TENANT PURCHASE SCHEME

As Figure 1 shows, a dramatic reversal of this chain of events appeared
to have taken place in December 1997.
On 8 December 1997 the Government announced a Tenant Purchase
Scheme (TPS) that would allow public housing tenants in designated blocks
to buy their existing units at as low as 12 per cent of the estimated market
value. Since public housing tenants were the primary source of buyers for
HOS housing and the structure of the more recent vintages of public housing
has become quite similar to HOS housing, the effect on HOS housing market
was immediate. Both prices and turnover fell precipitously. Because
HOS owners could not sell their units at good prices, they also could not pay
good prices for higher-tier housing. The owners of the latter, without the
HOS owners as their potential buyers, also had a hard time buying still
higher-level homes. Even luxury homes are affected. As a result the
entire housing market was paralyzed. Figure 2 shows that, excluding the
TPS transactions which involved sitting tenants buying their own flats,
second hand transactions dropped precipitously in the first quarter of 1998.

Figure 1.
187
Price Index of Private Residential Property
Index
500
450
400
350
300
250
200
150
100
50
0
-.i
vi
00
00
r-:
00
..0
00
~
00
0'
00
00
Source: Rating and Valuation Department.
FiJ(Ure 2.
Percentage of Second-hand Transaction in Total Transaction
90
- - excluding TPS
including TPS
80
70
" ,
60
SO
40
30
20
10
0
'"~
'Ci
0--
..,.
'Ci
0--
r-:
0--
'"
r-:
0--
00
0--
'"
06
0--
a:.
0--
'"
~
year
Source: Census and Statistics Department, Centaline Property Agency Ltd., Housing Authority
188
By the time the SAR Government announced the nine-point rescue

package on June 23 1998 Hong Kong's housing prices and stock prices had
It is
both fallen by some 40 to 50 per cent from their recent peak in 1997.
fashionable to talk of this major asset price decline as the bursting of the
bubble and trace it to the Asian Financial Crisis. Yet it is most difficult to
explain why the deep depreciation of the Thai baht and the Indonesian
Rupiah has that much effect on Hong Kong's home prices. After all, not a
single bank had failed in the financial crisis. Our banks were also
extremely cautious, not only in routinely valuing property prices well below
market levels but also in providing loans at no more than 70 per cent of the
appraised prices. There was, moreover, during the peak or the recent lows,
no overbuilding. Although supply had indeed increased quite substantially
relative to the immediate past, largely in response to sharp price increases,
there was no overhanging excessive supply in 1998.
It is important to note that even at the peak of the property price cycle,
the greater majority of buyers were genuine users.
However
"unaffordable" the property prices were, the majority of the buyers were
ordinary people who spent their life savings on what were supposed to be
good inflation hedges. They were able to pay such high prices because they
were mostly already homeowners and thus were able to pay a substantial
down-payment with the equity realized through selling their existing homes.
It must be noted that in Hong Kong's market the average home had seldom
been for the entry-level buyer. The entry-level buyers had always been
paying much more modest and affordable prices for much more modest
homes. The Home Ownership Scheme housing flats were such kind of entrylevel housing.
To be fair, Hong Kong's homes were very expensive by international
standards, but that does not automatically mean they had to fall significantly.
Hong Kong's tax rates were among the lowest in the world, and that tends to
be reflected in much higher land prices. Compared to most other places,
Hong Kong is politically and socially much more stable, and its bright future
is almost guaranteed by China's rapid economic development and its fine
tradition of respect for the rule of law. Just as a very high rental yield
during the early eighties had reflected a deep uncertainty discount, so the
very bright future that Hong Kong faces means that Hong Kong' s property
prices perhaps rightly should reflect a premium based on these favorable
factors. Even more important, the big savings accumulated by many public
housing tenants through years of very low rent and economic upward
mobility continued to provide impetus to the housing market at large. 4 The
currency crisis in South East Asia did not mitigate any of these favorable
factors, and should not warrant the dramatic decline in property prices since
July 1997.
189
To be fair, Hong Kong's home prices in the middle of 1997 were

perhaps too high and could be due for a major correction. Hong Kong's
home-buyers knew that prices could fall. While it is totally legitimate for
market participants to form their own opinions about whether prices were
too high, however, it is totally wrong for the government to imagine what is
the right price and attempt to engineer a price decline to reach "more
acceptable levels." If the government does this, it will have given up its
role as the custodian of the free market and will have become anti-market
and unnecessarily interventionist.
4. THE STATISTICAL EVIDENCE

Table 2 shows that the introduction of the Tenant Purchase Scheme has
an additional and very significant dampening effect on second hand
transactions in the housing market over and above the effect of the Asian
Financial Crisis, which occurred in the third quarter of 1997. I use the
volume of transactions in existing homes as the dependent variable, and I use
the difference between the spot exchange rate and the one-year forward rate
to proxy the financial crisis. This CRISISDUMMY variable is non-binary,
but normalized to have a minimum value of zero and a maximum value of
unity. PPIMR is a price appreciation variable. In general, if prices rise
faster second hand transactions will also rise.
Table 2. Dependent Variable: Second hand transaction volume: TRANSACT2 (l996M3 to
2000M2)
T-ratio
Variable
Coefficient
12.067***
Constant term
10261.0
CRISISDUMMY
-1.7952*
-2949.1
-2.8409***
TPSDUMMY
-3965.3
1.5030
PPIMR
33.289
R-bar squared
0.49601
DW-statistic
2.0709 The Cochrane-Orcutt AR (1) procedure was used to correct for
serial correlation.
*** means statistical significance at 1 per cent level
means statistical significance at 10 per cent level
*
Table 3 shows the results of a regression exercise that seeks to explain

changes in private sector domestic demand (NETDOMDER) in Hong Kong,
which is simply the sum of private consumption and investment. The unit
of the dependent variable is percentage change. S1 and S3 are seasonal
dummies for the first and the third quarters. GOVE90R is the rate of
change of real government expenditures on goods and services. Such
190
expenditures should have a POSItIve impact on private sector domestic

demand through the multiplier effect.
Similarly, EXPORT90R, and
EXPORT90R (+ 1), which are the rates of change of real exports, current and
leading one quarter, have an impact on private sector domestic demand
through the multiplier effect. Because production precedes actual exports
the lag structure is advanced one quarter relative to that of government
expenditures. A priori, I expect that both exports and government
expenditures have positive effects on domestic demand.
Because
GOVE90R (-1) does not have a statistically significant coefficient it was
dropped. Finally, the real interest rate 5 and inflation have negative effects
on domestic demand.
We can see that all the estimated coefficients have
the expected signs.
Table 3. Dependent Variable: NETDOMDER, 1984 Q2 to 1997 Q4
Variable
Coefficient
Constant term
7.0249
SI
-8.9173
S3
-7.7852
GOVE90R
0.26317
EXPORT90R
0.18427
EXPORT90R (+1)
0.16797
REALIMRA (-I)
-0.31523
GDPDEFRA (-1)
-0.23405
R-bar squared = 0.61719
DW-statistic
2.0674
* ** means statistical significance at 1 per cent level
* * means statistical significance at 5 per cent level
T-ratio
2.8052***
-2.9421 ***
-5.8722***
1.9948**
1.6075
2.4505**
-1.4794
-1.1353
Based on the parameters thus estimated, using data from 1984 Q2 to

1997 Q4, I forecast the effects on the rate of change or domestic private
demand. Along with the actual values of change, the forecast values are
tabulated below:
Table 3a. Forecast forNETDOMDER for 1998 Ql to 1999 Q3
Observation
Actual
Prediction
1998 Ql
-9.4982
-4.1557
1998 Q2
5.1774
3.3680
1998 Q3
-7.2065
-1.3093
1998 Q4
-3.9714
-0.6435
1999 Ql
-8.9805
-3.1268
1999 Q2
8.6339
5.8449
1999 Q3
0.4650
4.8060
Source: Based on regression results reported in Table 3
Error
-5.3425
1.8094
-5.8972
-3.3279
-5.8537
2.7890
4.3410
191
According to the forecast, which uses the realized values of the rates of
change of government expenditures, real exports, the real interest rate, and the
inflation rate, the actual decline in quarter 1 1998 was much larger than the
predicted value. The difference can be attributed to the implementation of the
TPS. Actually, the effect of the TPS may be even more serious than this,
because the SAR government had adopted a very stimulative budget since 1998,
giving generous tax rebates, an unprecedented mortgage interest deduction from
taxable income, interest-free home purchasing loans, etc. Moreover, competition
among the banks has driven mortgage-lending rates to unprecedented low levels
relative to the prime rate. Not counting these positive effects on the economy,
according to my estimates, by the end of the ftrst quarter of 1999, TPS had
resulted in a loss of 17.46 per cent of domestic demand. Largely as a result of
various stimulative measures adopted starting to take effects the cumulative loss
was reduced to 11.5 per cent by the end of quarter 3 in 1999.
Table 4 shows the results of a regression using a similar statistical model
but adding an additional CRISISDUMMY to capture any independent effect of
the ftnancial crisis that may have effects other than through exports and real
interest rates. The defmition of CRISISDUMMY is as explained above. We
can see that the variable carries the right, negative sign. It is not very
significant, but we will use the equation to do a forecast, which is presented in
Table 4a. We can see that adding the CRISISDUMMY does generally reduce
the negative errors of the forecasts, but it also increases the positive errors.
Thus it explains part of the economic declines. The slower predicted recovery
after 1999Q 1 compared to the previous model suggests that the stimulative
measures taken by the government may be more effective than is implied by the
model without including the crisis dummy variable.
Table 4. Dependent Variable: NETDOMDER, 1984 Q2 to 1997 Q4
Variable
Coefficient
Constant term
7.0875
SI
-8.7331
S3
-7.6637
GOVE90R
0.25724
EXPORT90R
0.18491
EXPORT90R (+1)
0.15887
REALIMRA (-I)
-0.31721
GDPDEFRA (-1)
-0.24168
CRlSISDUMMY
-1.4681
R-bar squared 0.61102
DW-statistic = 2.0539
*** means statistical significance at I per cent level
** means statistical significance at 5 per cent level
*
T-ratio
2.8043***
-2.8381 ***
-5.6434***
1.9267*
1.6002
2.2242**
-1.4765
-1.1600
-0.50375
192
Table 4a. Forecast for NETDOMDER for 1998 QI to 1999 Q3

Observation
Actual
Predication
1998 QI
-9.4982
-5.0188
1998 Q2
5.1774
1.9839
1998 Q3
-7.2065
-2.6994
1998 Q4
-3.9714
-0.9596
-8.9805
1999 QI
-3.6761
1999 Q2
8.6339
5.5848
4.8060
0.2956
1999 Q3
Source: Based on regression results reported in Table 4
Error
-4.4794
3.1935
-4.5071
-3.0118
-5.3044
3.0491
4.5104
Many people blamed the Tung Administration for setting a yearly

production target for housing units and called this central planning. Yet
there is nothing intrinsically wrong with such a strategy. Given that the
Government is the producer of buildable land and the largest supplier of
such land in Hong Kong, there is a need to have a vision as to how much
land is to be released each year. A land release strategy based on a
production target that is set in the light of demographic trends and economic
growth projections seems logical and should be superior to any other kind of
strategy.
It is not clear how the Government came up with the annual production
target of 85,000. What is clear, however, is that behind this annual
production target is the intention to bring down home prices, and this would
be wrong. A total of 85,000 units, with 50,000 units coming from the
public sector and 35,000 units coming from the private sector, as proposed
by the government, 6 would be a significant departure from the trend average
of about 70,000 per year over the past ten years.
It could be justified only
if the population increase and income growth were both expected to be much
faster than before. The maturing of the Hong Kong economy suggests that
trend economic growth over the next ten years should be much more modest
than that of the past. This immediately calls into question the wisdom of
increasing the supply of housing to the extent proposed.
Although the effects of the TPS, neatly described as a disruption to the
ecology of the housing market, are explained in sequential order, they
actually took effect immediately. This is like a train engine pushing a
series of linked carriages: even though the force comes from the engine at
the end of the chain there is virtually no difference in the timing of the
motion of the first carriage as compared with the last. Moreover, we have
good reasons to believe that the prices of luxury homes, which corresponds
to the theoretically last "carriage" affected, would fall even more than the
entry-level homes do. Luxury homebuyers are almost always already
homeowners and such owners depend entirely on their ability to sell their
193
existing homes before they could buy better ones. On the other hand the
entry-level homebuyers have never owned homes before and have all along
depended on their cash savings for their buying power.
The injury from the collapse of home prices is deep and wide. Some
homeowners have lost all their equity and have become net debtors. Some
have actually lost both their homes and their jobs, and have been pushed to
the brink of bankruptcy because their lenders will continue to chase after
them for the balance of the amount loaned to them upon selling the collateral
properties at very low prices. These impoverished homeowners, ironically,
were among the most productive within Hong Kong's labor force and had
more than their fair share of commitment and trust in Hong Kong's future.
Many of them have never had the benefit of receiving subsidized housing
from the Government. The great risk to Hong Kong is that they may be so
disheartened that they dared not buy homes again in the future, even if they
regained the ability to do so. Rather than putting money into their homes in
Hong Kong, they may simply ship their savings out of Hong Kong. The
result would be massive and continuing capital flight, while the dream of
realizing the 70 per cent homeownership target becomes more and more
remote.
The collapse in turnover in the housing market is particularly damaging
for the Hong Kong economy. Because a number of key sectors depend on
housing turnover for their business, the collapse in turnover virtually eroded
the basis of their survival. Foremost among those taking the brunt of the
shock is the property brokerage sector. Others also hit seriously include
decorators, movers, lawyers, bankers, stockbrokers, retailers, sellers of
construction materials, and of course real estate developers. As the values
of properties fall, the banks had to curtail their lending activities--the worst
thing to happen at a time of high interest rates. As a result other sectors are
also hit. In a matter of four months, Hong Kong's unemployment zoomed,
from an average of 2.5 per cent in the November 1997 to January 1998
period, to an average of 4.2 per cent in the March to May 1998 period. By
February 1999-April 1999, the unemployment rate reached a high of 6.3 per
cent.
The rise in the unemployment rate was, however, not entirely due to
a loss of jobs. Hong Kong's labor force was growing rather rapidly partly
as a result of popUlation growth and partly as a result of rising labor force
participation, which is most noticeable among women.
The effects of the TPS on employment can be inferred from Table 5,
which clearly shows that employment growth is positively and significantly
related to changes in the volume of transactions in homes (HMDEEDSC).
Given that the volume of home transactions had fallen after the introduction of
the TPS, employment growth must have been significantly reduced by the TPS.
194
Table 5. Dependent Variable: Change in Employment in Millions (1984Q3 to 1997Q3)

Variable
Coefficient
T-ratio
Constant term
0.02631
4.2338***
SI
-3.9369***
-0.04087
S3
-2.5946***
-0.03128
EXPORT90C (-1)
0.35402E-06
1.5606
HMDEEDSC
0.12518E-05
2.0350**
R-bar squared = 0.28736
OW-statistic = 2.3706
*** means statistical significance at 1 per cent level
**
As the economy took a tailspin downturn, the SAR Government's

fiscal revenue plummeted. Land sales of course turned in far less revenue
than originally forecast. Appeals to sharply reduce land premiums to be paid
for conversion of land use and for upzoning jumped, while any land
premiums to be collected for similar purposes fell. Meanwhile, profits tax,
stamp duty, even salaries tax, all declined sharply. As a result, the
Government ran a fiscal deficit in 1998/99, and was able to avoid another
deficit in 1999/2000 only because of the huge capital gains achieved
subsequent to the incursion in the stock market in August 1998. 7
5. RESCUE ACTIONS
The SAR Government's first budget, announced on February 18, 1998
was a significantly stimulative one and was designed as a rescue package.
It gave a tax relief to everyone. The basic personal allowance was raised
by 8 per cent. An unprecedented deduction for home mortgage interest
payments up to $100,000 per year for five years is given to all owneroccupiers. The profit tax rate was reduced from 16.5 per cent to 16 per cent.
The rate of stamp duty on stock transactions was cut from 0.3 per cent to
0.25 per cent. Rates chargeable on properties were reduced from 5 per cent
to 4.5 per cent. These and other measures on the revenue side were
expected to cost $13.6 billion in 1998-99 and nearly $100 billion up to 200102. These measures, together with a symbolic interest rate cut in February,
prompted the property market into action, as both turnover and prices
recovered noticeably.
However, the revival was short-lived, largely
because the fundamental problems, namely an excessively large housing
production target and a disappearance of buyers of HOS housing as a result
of the Tenant Purchase Scheme, remained.
The continual and sharp rise in unemployment prompted the
government into rescue action again, as a high level committee was formed
195
to deal with the situation. The 12-point rescue package announced on June
3, 1998 included stepping up the training programs, accelerating hiring
procedures for civil servants, and bringing forward the infrastructure
program. At about the same time, the Housing Authority announced it
would allow tenants of retail premises in public housing estates, whose
leases were due to expire in 6 to 31 months, to apply for a reassessment of
rent.
Came June 22, 1998. The Government was about to auction two
pieces of land the next day. The Financial Secretary and then the Chief
Executive together with a panel of top government officials suddenly
announced a further nine-point rescue package, the most controversial and
striking component of which being a halt to all land sales through the end of
the fiscal year in March 1999. Market reaction was positive, as the number
of viewers for homes put on sale jumped. The stock market, though,
reacted coolly. The atmosphere in the financial market was so pessimistic
that people were skeptical about the effectiveness of the proposed measures
and took a wait-and-see attitude rather than going on a buying spree.
6. WHAT SHOULD BE DONE?

Many people blame the linked exchange rate system of Hong Kong for
the poor performance (see for example the numerous editorials in the Hong
Kong Economic Journal). There is no doubt that the linked exchange rate
system has something to do with the severity of the crisis. In this regard,
Singapore's system of implicitly linking to a basket of currencies is much
wiser. I have argued for a basket link and invented a mechanism for an
easy and transparent system to produce just that back in 1990 (Ho, 1990).
But another problem is that the Hong Kong Monetary Authority had kept
Hong Kong's interest rates high-much higher than US interest rates--for
too long. I have argued elsewhere, the damage of very high interest rates
may not be salvaged even if interest rates fall steeply later on, because once
a firm or an individual has gone bankrupt, lower interest rates would not
help (Ho, 1998b). Singapore, on the other hand, aggressively reduced
interest rates not long after the Asian Financial Crisis. 8
A more serious policy error made by the SAR Government, as this
chapter shows, is the way the Housing Authority privatized its public rental
housing stock. As yet the SAR Government has not yet recognized its
mistake. The Housing Authority continued to expand the Tenant Purchase
Scheme. The Government, clearly in an attempt to revive the property
market, had expanded the quotas for home purchase loans while converting
some of the Home Ownership Scheme housing into rental units. Adding to
196
the irony, many of those homeowners given interest-free loans to buy homes
had become negative equity holders.
In order for the housing market to recover it is necessary for the
Government to formally revise downward its long-term housing production
target, and put forth a credible, revised land sale program that is consistent
with the revised target. The Government has to rework its public housing
sale program so as to push the better-off public housing tenants to the HOS
or the private housing market.
The public housing privatization scheme
must exclude all households not meeting the prevailing criteria for eligibility
for public housing. Privatized public housing units should also be subject
to a resale restriction such that they can be resold only to buyers meeting the
criteria for public housing.
Does this mean that I recommend going back to a so-called "high land
price" policy? Not at all. As a matter of fact, I must point out that no
government can successfully implement a "high land price" policy against
economic fundamentals. Can Indonesia today implement a high land price
policy and keep the economy humming along? Could Macau (formerly a
small Portuguese colony an hour's hover ferry trip from Hong Kong) have
implemented a high land price policy and actually attract real buyers who
paid prices anywhere near Hong Kong's land prices?
Hong Kong's land
prices were high because people were willing and able to pay for those
prices. Would making land available cheaply have transformed Hong
Kong's economy into one that was stronger than it had been? Had Hong
Kong done so, Hong Kong would have needed much higher tax rates to
finance its government functions. If the Hong Kong Government had
always supplied so much land that land prices never rose, Hong Kong
belongers would have been deprived of the opportunity of using their homes
as their primary store of value. Hong Kong people probably would have
remitted their savings away to some offshore places that promised better
returns. If Hong Kong's home prices had been stagnant, the drive to save
more to buy better and more expensive homes would have been averted.
The economy would have been much less vibrant.
Some people say that elsewhere people pay low housing prices and
high taxes. In Hong Kong people pay low taxes and high housing prices.
The total burden is no different. Some people also say that Hong Kong
people actually pay high taxes because they pay so much for the land cost.
Indeed land costs, land premiums, stamp duties on housing transactions, etc.,
boil down to a tax of another form. The crucial question is: which kind of tax
provides better incentives for people to work hard and to create wealth? In
the late 19th century, the American economist Henry George advocated a
single tax on land as the least distorting of incentives. My conjecture is that
he is right. According to him, as society progresses, land values increase,
197
and it is right for the government to collect the increase in site values. This
is exactly what the Hong Kong Government has been doing. When the
developmental value of land has increased to a certain level, developers
often want to redevelop their land at higher densities. In Hong Kong such
requests are often entertained, subject to planning considerations, provided
that they pay the necessary premiums. Is this a good system? Hong
Kong's long history of economic success suggests yes.
Such a policy is not quite the same as a " high land price policy." A
high land price policy may be defined as one that is designed with the
intention of drawing the largest possible revenue from land sales and from
land redevelopment levies. This is not what I would recommend. My
recommendation is only that for any year land should be supplied as long as
the marginal value to society of supplying it is larger than the full marginal
cost. The full marginal cost includes the cost of preparing the site and
providing the necessary infrastructure links to service it as well as the cost of
possible instability added to the housing and the financial market. On June
22 1998, when the Government announced a moratorium to land sales for
the rest of the fiscal year, the latter cost was likely to be extremely great.
Given that the availability of credit in the banking system is already low,
land sale would be badly timed because, like an open market operation made
by a central bank, it would suck in liquidity from the market and thus would
amplify the credit crunch. For this reason I applauded the halt to land sales.
But over the long run something more fundamental has to take place. The
government should abandon or amend the public housing privatization
program.
7. CONCLUSIONS
Just as a misguided macroeconomic policy can cause crisis to an
economic ecological system, as discussed in the last chapter, a misguided
micro economic policy can also bring havoc to an entire economy, as the
example discussed in the chapter has shown. The economic system is a
system under "general equilibrium." Different components hang together
in a rather delicate fashion.
Some components, in particular, are
particularly important because other components may depend on them so
much, directly and indirectly. The rapid development of information
technology and the increased division of labor through trade are making the
ecological system even more delicate. By learning to understand how the
economic ecological system works, however, it is possible to harness this
development and reduce instability. Public policy makers should exercise
great care and caution when they ponder the introduction of highly leveraged,
198
financial market derivatives which are very sensitive to financial news and
interest rate movements, and when they introduce new policy initiatives,
particularly in sensitive areas that have to do with peoples' savings. The
example of Hong Kong demonstrates, loudly and clearly, that we have to be
extremely cautious in dealing with peoples' life savings. Savings drive
investment and future consumption. Housing is an important element in
the economic ecological system in part because it is often the depository of
life savings, and in part because it is often a highly leveraged product in the
sense that people have to take out a large loan to acquire the asset. For this
reason policies with regard to housing should be worked out carefully.
NOTES
2
3
4
The Cultural Revolution started on the Mainland but spread to Hong Kong quickly.
People were killed in street riots. Bombs were set off. Property prices slumped.
Not seasonally adjusted. The largest decline in the first quarter on record was 9.3 per
cent, in 1989.
"Safeguarding Rational Allocation of Public Housing Resources: A Consultation
Document" published by the Hong Kong Housing Authority in December 1995.
Watanabe (1998) presented figures showing that public housing tenants saved much
more than HOS owners, private housing ter:ants, and private housing owners, in
absolute and relative terms.
This is the standard mortgage rate, equal to the prime rate +1. 75 up to February 1996,
but declining smoothly to a weighted mortgage rate applicable at the start of 1999,
minus the quarter-to-quarter GDP implicit deflator inflation rate annualized ..
Mr. Tung Chee-wa, Chief Executive of the Hong Kong Speical Administrative Region,
announced in July 2000 in passing while speaking to reporters that the policy of 85,000
units production target per year "was gone in 1998"-notwithstanding a member of the
Executive Council maintaining the contrary just a week before he made those remarks.
The government bought over HK$1 00 billion worth of shares in August 1998 while the
Hang Seng Index was around the 7000 level. In August 2000 the Hang Seng Index
was around 17000.
From September 15, 1998 through December 10, 1998 Singapore reduced interest rates
five times, bringing the prime rate from 7.5 per cent to 5.5 per cent. In contrast, Hong
Kong's prime rate started to drop from 10 per cent on October 19 1998, but remained
at 9.25 per cent on December 7.
Epilogue
Chapter 19
PUBLIC POLICY IN THE NEW MILLENNIUM
1. BACKGROUND
The new millennium is characterized by five major trends. Evidently,
public policy making has to fully appreciate the impact of these trends on
human society and respond accordingly.
These trends are:
the trend of globalization and intensifying competition,

major technological breakthroughs promlSlng major increases in
longevity and improvements in information processing and
transmission,
increasing inequality in income and wealth distribution, both globally
across nations and domestically across the population,
continuing unrest in Africa and transitional economies like Russia and
some Latin American countries,
increasing interdependencies underscoring the need to appreciate the
ecology of economic systems.
These major trends are posing important public policy questions that
policy makers around the world have to face. Policy makers cannot and
must not deny these underlying trends. If policies are not set right, these
trends could lead to a more turbulent and dangerous world. On the other
hand, if policies are appropriate, globalization and technological
breakthroughs will bring major advances in human welfare, while the unrest
in transitional economies will be arrested.
202
2. PRINCIPLES OF PUBLIC POLICY THAT WORK

WITH GLOBALIZATION AND COMPETITION AND
RISING INCOME INEQUALITY
Principle of Information Cost Minimization, Principle of
Availability of Alternatives, and Principle of Residual Risk
Reduction
The proposal of a World Currency Unit is a workable proposal that will
produce big benefits in a world of increasing globalization and competition
(Chapter 11). This is because it is a standardized unit of account that can
reduce information cost for savers and investors. Holders and issuers of
bonds denominated in the WCU know what interest rate, in real terms, they
are earning or paying. To the extent that savers and investors around the
world use this standardized unit of account the information content of
interest rates becomes clearer, competition becomes more effective, and the
world capital market becomes more efficient. To the extent that savers
have such global indexed bonds as an instrument to hold their savings, the
need to put money in bubble-prone assets will be diminished. The
availability of this alternative should reduce bubble formation, thus
rendering our international financial markets more stable. Because the
WCU is implicitly diversified among five major currencies, exchange risks
are reduced for savers and investors.
Principle of Fair and Open Competition

Globalization is an ongoing world trend and the clock cannot be turned
back. Despite the street riots in Seattle protesting against globalization at
the WTO meeting in December 1999, no one can stop globalization.
Globalization does mean that workers in North America will face the
competition of low wage workers in emerging economies. They may decry
the low wages and poor working conditions of these "sweatshops," but the
availability of these jobs, however lowly paid, improve the welfare of the
employed workers. If we are concerned about the welfare of these people,
we will not condemn globalization. We would ensure that the workers
have a reasonable working environment and safe working conditions rather
than trying to undermine the principle of fair and open competition.
Public Policy in the New Millennium
203
Redistribution and Safety Nets

Globalization does mean that income and wealth distribution may
become more skewed than ever.
Successful businesses will thrive.
Unsuccessful ones will be wiped away. Skilled workers whose skills are
wanted by a growing market will find their wages rise spectacularly. Other
workers may find their wages stagnant or even decline, or worse still, their
jobs may be eliminated. Globally productivity will rise. Products will
become cheaper and better. But for the unemployed there are no cheers.
There will therefore be greater need for safety nets and for redistribution.
Governments ensuring the availability of basic jobs will see their societies
not so vulnerable to crimes and will be attractive to investors.
Redistribution through wage subsidies of the kind discussed in Chapter 16
will prove a stabilizing factor for society and will foster a greater sense of
social justice.
3. PRINCIPLES OF PUBLIC POLICY THAT MAY

ARREST SOCIAL UNRESTS
Fiscal Health and Public Policy
The kind of social and economic problems currently inflicting such
socially turbulent countries as Russia and some of the African countries and
other transitional economies is certainly highly complex. There is clearly
no easy solution to such problems. However, it is also clear that the
ineffectiveness of the government, which is in part due to the very poor
fiscal positions of the governments concerned, is a key factor behind all the
problems. If the government cannot afford to pay its employees and these
employees wield power, there is little wonder that they would resort to
corruption to boost their incomes. If the police, the army, and other
government officials are all bribable, we will have an everything-goes
society. No one will invest unless one is backed up by powerful people.
Widespread unemployment and crimes are inevitable.
Shleifer and Vishny (1993)'s model suggests that a corrupt government
whose departments work together to maximize joint profit is superior to one
whose departments independently try to maximize their own profits.
Obviously, it is in such a government's interest to maintain law and order to
the extent that private enterprises can operate and can pay bribes. A
thoroughly corrupt government still has to run like an enterprise. You
204
cannot expect such a government to defend social justice in any sense, but if
it can keep the economy going, some kind of stability can be achieved, and
this would be a big improvement over what would happen if the government
cannot function.
Principle of Availability of Alternatives and the Deterrence

Principle
Once the government has achieved some degree of fiscal health it will
be able to start paying its employees. Only when these employees earn
sufficiently to maintain a living can we start to fight corruption. If
government employees particularly the police and the judiciary enjoy a
reasonable salary, and if the government makes available "basic jobs" to
anyone who seeks jobs, then the government can apply the deterrence
principle to deter people from committing crimes. Only then will people
have the choice to lead a crime-free life.
The deterrence principle is to use punishments to prevent crimes.
Traditionally people take prison terms as a humane form of punishment and
corporal punishments to be inhumane. Chapter 5 shows that this need not
be true. Deterrence is always achieved through pain of a physical or a
psychological nature. Detaining someone for months and years produces a
psychological pain on the culprit, and negative spillover effects on the
taxpayers and the culprit's family members. There is no proof that
psychological pain is more civilized or more humane than physical pain.
Judicious use of physical pain as a deterrence can be fairer, more economical,
more humane, and more effective than prison terms.
4. PRINCIPLES OF PUBLIC POLICY THAT FULLY

CONSIDER BREAKTHROUGHS IN BIOTECHNOLOGY
AND MEDICINE
The Fully Funded for the Cohort Principle
The next decade or two may see major breakthroughs in medicine that
are made possible by genetic engineering and biotechnology, following the
recent advances in knowledge about the human genome. It is no longer
unthinkable that human life expectancies in socially and politically stable
countries extend well beyond 100. Already recently there were reports that
205
traditionally estimated life expectancies had been significantly

underestimated. This means greater risks for public pension schemes that
run on a pay-as-you-go principle.
The proposal for a fully funded pension plan for each cohort (Chapter 8)
therefore deserves attention from policy makers. Although the general
point that productivity advances and immigration could offset the effects of a
rising dependency ratio that may be driven by demographic dynamics is well
taken (Papadimitriou and Wray, 1999), no one can deny the fact that the
sustainability of pay-as-you-go pension systems (unless they are very smallscale and pay tiny pensions) depends on chance. By making each cohort
save for its own retirement and allowing members within the cohort to
benefit from the pooling of longevity risks, members of a cohort are
protected from the risks of not having saved enough for retirement. If the
cohort discovers that its life expectancy has significantly improved the entire
cohort may have to postpone its retirement age, but the financial burden of
sustaining itself through a much longer retirement period will not be shifted
onto the younger generation.
5. PRINCIPLES OF PUBLIC POLICY THAT UPHOLD

SOCIAL AND ECONOMIC JUSTICE
The Principles of Universality, Excessive Burden Insurance,
and Ex Ante Welfare Maximization
Advances in medicine and medical technology may also significantly
increase the cost of caring for the sick. Are we prepared to pay for the cost
of caring for the sick? Suppose it costs a million dollars to extend one's
life for ten years, and it is a functionally healthy ten years, are we prepared
to pay for it? Suppose we are behind a veil of ignorance and do not know
which one of a hundred among us will be hit by such a health problem in our
life-time. Are we willing to pay for it?
If we consider all of ourselves as equals, and we abhor the condition of
helplessness caused by the prospect of not being able to pay for a surgical
operation that can extend a functionally healthy life for ten years, we may
well decide in favor of excessive burden health insurance. Excessive
burden insurance requires that we pay for the cost, up to a point per year, of
our own medical care. Beyond that point, however, taxpayers will come to
our aid, and we will have the life-saving medical care regardless of how
expensive it is (Chapter 5).
206
Do we all feel better off with such a system? If we feel better off
living in a society that provides such excessive burden health insurance and
so choose to pay heavier taxes for it, we are maximizing our ex ante welfare.
Each of us does not know if he will actually benefit from it (as assumed,
only one in a hundred will benefit from it). But it enhances our state of
well being since we know that we will not fall into the state of helplessness
which we so much abhor.
Should the system be available to all within the society? I believe yes.
This principle of universality for benefits of an insurance nature has been
unfairly criticized as allowing people with better means to enjoy benefits
which are targeted at the poor. The fact is that universality is not only
administratively simpler to implement than a system based on means-testing,
but it is also fair in that even though better-off people also benefit, it is also
the better-off people who pay taxes. From this perspective, the poor, nontax-paying people never subsidize the better-off. It is only the better-off
people who pay for the benefits enjoyed by the poor. The principle of
universality only additionally allows the better-off people to "insure among
themselves."
6. PRINCIPLES OF PUBLIC POLICY THAT PREVENTS

OR MINIMIZES FINANCIAL CRISES AND CONTAGION
EFFECTS OF FINANCIAL CRISES
Principle of Enlightened Monetary Policy that Keeps

Monetary Conditions Close to What is Required for a
Healthy Economy
The eve of the new millennium saw the introduction of many financial
market innovations many of which work on the leverage principle. It also
saw a big revolution in information technology. Against this background
almost all financial markets have turned global in the sense that, although
participation may not be global, the ups and downs of all markets are
monitored around the clock all over the world.
These developments have made diversification on a global scale
possible for the average investor, and this obviously helps reduce risks. At
the same time, however, the influence of mass psychology and herd behavior
have become greater than ever, as investors nervously watch what other
investors are doing. Given the effects of leverage, big profits readily turn
into big losses and vice versa. The kind of gyrations in stock market
207
indices, interest rates, and exchange rates that have occurred in individual
markets during the 1980s and 1990s dwarf the stock market crash of 1929.
While the financial markets have become more volatile, the real
economy has become more stable, thanks to a much more enlightened
approach to monetary policy by the Federal Reserve under the leadership of
Alan Greenspan. The American economy has registered the longest
economic expansion in history. Following the debacle of Long Term
Capital Management in 1998, the Federal Reserve coordinated a bailout for
the hedge fund-not in order to save one private company, but in order to
contain the damage. The Federal Reserve these days does not make any
assumption about the "natural rate of unemployment" and clearly weighs
costs against benefits when it deliberates on the conduct of monetary policy.
There is no doubt the continuing economic prosperity of the United States
has served as a major stabilizing force for the world economy.
This is not to say that policy makers around the world have learnt to be
flexible and enlightened. The Asian Financial Crisis of 1997-98 is a case in
point. On the eve of the crisis, a number of Asian currencies were
overvalued and were suffering from already high real interest rates. The
problem had to be relieved through devaluation and reducing interest rates.
Instead, although currencies were devalued, interest rates were raised to
back-breaking levels. One enemy was chased away but an even worse
enemy was brought back. In contrast, the "sterling crisis" of 1992 turned
out to be a blessing for the UK economy. While the sterling was devalued
UK interest rates were also reduced. The enlightened monetary policy
jumpstarted the economy. This happy ending and the unhappy episode
before the sterling delinked with the European Monetary System explain
why the United Kingdom is still hesitant about joining the Euro.
International Lender of Last Resort

When a currency is under attack and is seen to require a devaluation,
very often the devaluation is what is needed. The fundamentals of the
economy will be improved by the devaluation, other things being equal.
However, given human nature as it is and imperfect perception, speculative
pressures if allowed to run their course could render the devaluation
momentarily excessive.
Excessive devaluations can be destabilizing
because they can lead to serious inflation. To avoid this scenario some
central banks may choose to raise interest rates but this could render the
monetary conditions excessively contractionary again. Actually, however,
this is not necessary. After the exchange rate has been allowed to come
down to levels consistent with full employment and thus consistent with
208
macroeconomic balance requirements, the new exchange rate can be said to

be defendable. At this point, the country should have access to lending
facilities to defend the defendable exchange rate. The country should
borrow as much as needed and other countries should lend as much as
needed, through some kind of international lender of last resort mechanism.
This way the damage can be contained, and the contagion can be stopped.
7. DEMOCRACY AND THE NEW ENLIGHTENMENT

Principle of Pragmatism
The last century has seen a lot of attention devoted to the cause of
democracy. The new millennium will see a new enlightenment marked by
pragmatism. People will awake to the fact that democracy in the sense of
multi-party politics and general elections is neither a necessary nor a
sufficient condition for economic and social justice. Multi-party politics
and general elections are neither a necessary nor a sufficient condition for a
clean and effective government, a stable society, full employment, and
protection against misfortunes. The success of the authoritarian China and
the flop of the democratic Russia is the case in point. Of course it will be
that much nicer if China is, in addition to being able to feed and house its
people and giving them a realizable dream for a better future, also
democratic. But what really counts is not whether the government derived
its legitimacy from a general election, but rather whether the government can
effectively contain crime and corruption and protect basic human rights,
whether investors feel comfortable enough to invest in the country, and
whether the government can maintain a stable currency and contain inflation.
Principle of Autonomy and Choice and Principle of

Maximization of Ex Ante Welfare
The philosophy of democracy is founded on the assumption that people
are different and need representation, so that the political process is needed
to balance the interests of different groups. The theoretical basis of this
book is that we should assume people in fact share similar aspirations and
needs, even though they may each like to find different ways to manifest
those aspirations and satisfy those needs. People need protection against
excessive burden. People need food and clothing. People need the
209
freedom to express themselves and exercise their creativity. People need a

reliable instrument to hold their savings and a stable value currency.
People need recognition and social acceptance. While governments should
respect people's choice and autonomy, the purpose of public policy is not so
much to play one group's interest against that of another, but rather to
maximize ex ante welfare for everyone of us.
8. CONCLUSIONS
Jeremy Bentham believed that society should pursue the "greatest
happiness of the greatest number." Modem economics developed the
concept of "social welfare function," which is a mathematical function based
on the welfares of all individuals constituting the society. Maximizing the
greatest happiness of the greatest number, or maximizing the social welfare
function, however, has serious conceptual problems, and is not very helpful
for public policy. Bentham's approach requires knowing the ex post
welfare of all individuals and adding them up. There is also the strange
implication that increasing the population may enhance social welfare even
though the welfare of the existing population declines. Other forms of the
social welfare function is equally problematic, since there will never be a
consensus over the form of the social welfare function.
The approach of this book is that starting from the assumption about
the commonality of human nature, public policy should aim at maximizing
the ex ante welfare of you and me, you and me being no different "under a
veil of ignorance." We will not worry about A's and B's ex post welfares.
We will not take $100 from A and give it to B on the ground that ex post A's
loss is known to be smaller than B's gain. We will treat A the same as B,
and ask ourselves whether it is socially desirable to take $100 from someone
and give it to another against his will.
Maximizing ex ante welfare, we will protect A as well as B against
arbitrary income redistribution. We will protect A as well as B against
natural misfortune by setting up an insurance mechanism and we take solace
at the fact that since both A and B opt for the insurance they must be better
off ex ante. Rather than playing one person's ex post gain against another
person's loss, public policy should aim at enhancing ex ante social welfare.
By designing institutions that are socially just, conducive to mutual trust and
respect, and allow the biggest room for each individual to live his own way,
we will have a world that will allow us to realize the best within ourselves.
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INDEX
addictive drugs, 23, 137, 138

adverse selection, 88, 91, 96
Ainslie, George, 26, 27, 211
Argentina, 113, 131
Arrow, Kenneth, 41, 42, 52, 54, 211
Asher, Mukul G., 89, 97, 211
Asian Financial Crisis, 99, 109, 112, 118,
124,125,130,174,183,184,185,
188,189,195,207,216
Auerbach, Alan J., 89, 211
autonomy, 17,28,34,39,41,51,53,63,
67,68,144,147,148,209
Bank of Canada, 15, 131,213
Bank of England, 106, 110, 180
Basic Income Guarantee, 169
basic job, 133, 163, 166, 167, 168, 170,
203,204
Basic Law of the Hong Kong Special
Administrative Region, 136
Baumol, W.J., 164,211
benefit-cost analysis, 15,30, 151
bequest, 48, 55, 89
Bernanke, Ben, 179,211
Bernoulli-Morgenstern-von Neumann
theory, 32
Bierman, Harold, Jr., 174,211
Blinder, A.S., 164, 211
bubble, 99, 112, 117, 118, 120, 123, 124,
126,141,174,184,188,202
capitation, 61
Card, David, 164,211
Central Provident Fund, 14,66,89,97,
155, 156
Chaloupka, Frank, 31, 211
charter schools, 148, 151
Clinton, Bill, 69,87, 148, 151
Coats, W.L. Jr., 122,212
coinsurance, 84
competition, 51, 53, 62, 63, 86,103,140,
144, 147, 148, 149, 191,201,202
conditional bidding, 157, 159
conditional fee agreements, 75, 76
conditional market, 157
corporate governance, 129, 132

corruption, 1,4,46,141,203,204,208
cost-push inflation, 104, 106
crime and punishment, 6, 13,37,49
currency area, 113
currency board, 104, 107, 113, 114, 131,
132
curriculum design, 143, 144
Davis, L.J., 83, 86,212
defendable, 109, 110,115,208
defendable exchange rate, 110, 208
deflation, 113, 178, 179, 181
degree of justness, 40
demand management, III
demand-side moral hazard, 65, 72, 74, 76
dependency ratio, 92, 96, 205
deterrence principle, 204
Diagnosis-Related Group, 74
Diamond, Peter, 87, 88, 93, 212
Dietz, Thomas, 35, 212
discount rate, 31, 32, 89, 90, 178
do liarization, 114
drug legalization, 137
economic fundamental, 109, 110, 115,
124,125,174,178,182,196
education, 6, 16,34,47,48,54,55, 133,
137,143-151,168
education vouchers, 148, 150
effective demand, III
effective exchange rate index, 131
efficient pricing principle, 161, 162
efficient pricing structure principle, 162
emerging economies, 202
equal opportunities, 44, 47, 48, 55
euro, 114
European Central Bank, 114
European Monetary System, 110, 112,
207
euthanasia, 13 7
ex ante perceived utility function, 20, 24,
29
ex ante welfare maximization, 17,35,41,
52, 54, 205
220
excess capacity, 65, 124, 126
excessive burden insurance, 60, 66, 68,
72,74,76,205
exchange rate, ix, 99, 107, 109, 110, Ill,
113, 114, 118, 119, 120, 122, 125,
126,131,183,189,195,207
exchange risk, 114, 117, 122, 123, 124,
202
exchange risk premiums, 114
exploitation, 37, 47
Federal Reserve Board, 107, 180
Federal Savings and Loans Insurance
Corporation, 83
fee-for-service model, 59
Ferguson,J.David, 173, 176, 179, 181,
182,213
filtering down, 153
financial intermediation function of banks,
126
fiscal deficit, 15, 18, 112, 115, 136, 194
fiscal deficits, 15, 112, 115
Fisher, Irving, 178, 182
floating exchange rate, 110, 125
flow in the housing market, 153, 156, 158
Fogel, Robert, 97
fraud, 83,91, 166, 167
Freeman, Katherine B., 36, 212
Freeman, R.B., 164,212
Friedman, Milton, 39, 54, 105, 165, 169,
181,212
Fulfillment attributes, 21
fully funded for the cohort principle, 204
fully funded social security, 88, 89
fundamental justice, 39
Galbraith, John Kenneth, 36, 176, 177,
212
gate-keeping, 72, 73
generational accounting, 89, 97
George, Henry, 141, 196
German hyperinflation, 102
globalization, 201, 202
Gokhale, Jagadeesh, 89, 211
gold standard, III, 180
Great Depression, 99, Ill, 171, 173, 174,
176,177, 178, 181,211,213
Great Proletariat Cultural Revolution, 183
Greenspan, Alan, 15, 125,207
Grenville, Stephen, 130,213
Hall, Thomas E., 173, 176, 179, 181, 182,
213

happiness, 19,20,21,22,23,24,26,27,
38,40,54,144,145,150,209
Harsanyi, John c., xii, 27, 35, 36, 37, 38,
41,42,43,51,53,213
Haveman, Robert, 97
health policy, 6, 16
hierarchy of policy goals, 7, 10, 12
high land price policy, 196, 197
Home Ownership Scheme, 154, 158, 186,
188,195
Hong Kong, 3, 4, 12, 14,35,55, 59, 62,
65,71-86,88-97,101-115,121160, 183-198, 212-217
Hong Kong and Shanghai Banking
Corporation, 129
Hospital Authority, 62, 65
housing, 6, 12, 13, 121, 127, 132, 133,
153-159,168,169,184-198
Housing and Development Board, 154,
159
Housing Subsidy Policy, 127, 157, 185,
186
human genome, 204
human nature, xi, 5, 7, 9, 10,34,35,39,
104, 105, 130, 143, 145,209
human right, 163
Hungary, 102, 108
hyperinflation, 102
IMF, 115, 117, 118,217
income elasticity of demand for housing,
158
income-based safety net, 133
incremental justice, 37, 39, 43, 51, 52, 53
indexed bond, 108, 202
indexed global bonds, 122
indexing, 103, 108, 180
inflation, 12, 15, 18,99,101-106, 108,
111,115,117,121-126,131,132,
174,175,178,180,186,188,190,
191, 198,207,208
information cost, 79, 202
inheritance tax, 47
initial conditions, 47
inner reserve, 129
institutional choice, 40
international lender of last resort, 115,
207, 208
International Social Security Association,
95,214
interpersonal comparison of utility, 21, 30
Ito, Takatoshi, 120, 125, 131,213,214
Index
Iwaisako, Tokuo, 120,214
James, Estelle, 87, 91, 94, 95, 214
Jao, Y.c., 77, 82,214
Japan, 95, 99,110,112, 118, 119, 120,
121, 122, 123, 124, 125,214,216
jury, 13, 193
just society, 7, 11,37,38,40,41,43,44,
45,46,49,53,55,167
justice, 12, 13, 15,37-54,71,72,74,76,
95, 149, 156, 167, 168,203,204,
208
Kane, E.1., 83,214
Keynes, John Maynard, 47, 48, 106, Ill,
181,214
Kindleberger, Charles P., 180,214
Kotlikoff, Laurence 1., 89, 211
Krueger, Alan, 164,211
land-based revenues, 140
law and order, 4, 135, 141,203
Law Society, 72, 73, 75
Lawrence, Emily c., 31, 215
learning, 20, 22, 24, 25, 26, 30, 35, 145,
148, 197
legal aid, 60, 71, 72, 73, 74, 75, 76
Legal Aid Board, 73, 75
leverage, 118, 179, 181, 182, 197,206
life entrepreneurship, 26
life skills, 24, 25, 30, 33, 144
Long Term Capital Management, 207
longevity risks, 87, 88, 92, 94, 205
Lucas critique, 10
MaastrichtTreaty, 136
Malaysia, 14,89,97, 184,211
managed care, 59,61
managed care model, 59
mandatory private provident fund, 14, 92,
94, 97
marginal cost pricing, I 39, 161
market model, 59, 60, 61, 68
mass transit systems, 139
means test, 71, 72, 75, 91
Medicaid, 61, 69
Medicare, 61, 69
Medisave, 66, 69
mental bad, xii, 28, 33, 143, 145
mental capital, 24
mentaIgo od,28,29, 33, 34, 143, 145
merit test, 72, 75
Mexican peso crisis, 130
minimum wage, 12,97, 164, 166
Miron, Jeffrey A., 137,215
221
monetary policy, 15, 104, 106, 107, 108,
112, 113, 114, 126, 131,207
Montgomery, John D., 130,215
Musgrave, Richard A., 169,215
National Committee ofInquiry into
Higher Education, 143,215
National Health Service, 59, 62, 68, 69,
215
natural rate of inflation, 104
natural rate of unemployment, 104,207
negative income tax, 165
net creditor nation, 1 19
Nikkei Index, 119
Niskanen, William A., 59, 60, 68, 137,
216
Noguchi, Yukio, 95, 216
non-arbitrariness, 38, 45, 49
Office of Management of the Budget, 89
open market operation, 131, 197
opportunity cycle, 23
optimal degree of decentralization, 17
optimal size of government, 135
Papadimitriou, Dimitri B., 205, 216
Parieto risk efficiency, 54
pay-as-you-go, 87, 89,90,95,97,205
pegged exchange rate, 110, 125
perceivedfuljillment attributes, 24
perceived household production functions,
24
Peregrine Investment Holdings, 123
personal development, x, 20, 25, 34
picoeconomics, 26
Pingle, Mark, 29, 35, 216
policy-by-discretion, 131
policy-by-rule, 13 1
possibility theorem, 41
pragmatism, 208
principle of availability of alternatives,
202,204
principle of equal opportunity, 53
principle offair and open competition,
202
principle of information cost
minimization, 202
principle of insurance, 44
principle of residual risk reduction, 44
privatization, 87, 132, 139, 184, 196, 197
professional model, 59, 60, 62, 63, 68
Psacharopoulos, G., 143,216
public housing, 121, 154, 155, 157, 158,
159,184,185,186,196,197
222
racism, 33
rationality, xi, xii, 19,28,30,32,34,37,
51,52,126
Rawls, lohn, xii, 37, 38, 39, 41, 42, 43,
47, 5~ 51, 53, 55,9~9~211,215,
216
Rawlsian utility function, 54
real interest rate targeting, 107
real value unit of account, 99, 122
recession, 15, 18, 101, 104, 110, 111, 112,
115,132,176,179,180,181,183,
184,185
redistribution, 2, 3, 12,39,44,45,53,55,
74,91,92,94,96,97,133,140,
163, 168, 169, 203, 209
representative individual, 7, 17,23
residual risks, 43, 44, 49
Rickman, Neil, 73, 75, 213, 216
risk-related premiums, 81
risks, 2, 7,17,30,34,37,39,41,43,44,
49, 52, 53, 54, 57, 61, 75, 78, 81,
84,88,92-96,99, 108, 114, 117,
123, 130, 168,205,206
Rockoff, Huge, 178, 182, 217
Rodrigo, G. Chris, 130,216
rules of the game, 47
rules of thumb constraint to public
spending, 141
Sachs, Jeffrey, 11 7, 118
Sah, Raaj, 29, 216
satiation fluctuation cycle, 23
satiation/attribute cycle, 31
Savings and Loans (S&L) crisis, 83
Scanlon, Tim, 27,216
school curriculum, 144, 145
Schuler, Kurt, 131, 216
Seamless health care, 67
self-protection, 78, 79, 80, 82, 84, 130
Sen, Amartya K., 35, 41, 52, 54, 68, 215,
217
Shannon, David A., 177, 217
Shleifer, Andrei, 203, 217
Singapore, 4, 14,66,69,89,97, 154, 155,
156,159,184,195,198,211
Sirkin, Gerald, 174,217
size of the government, 135, 136, 138,
142
Smith, Adam, 19, 125, 178,217
Smoot-Hawley Tariff Act, 181
social safety net, 54, 163

social security, ix, 6, 37, 51, 53, 87, 88,
135
social welfare function, xii, 11,41,42,
209
socially embedded preference, 35
Soros, George, 110, 112
South Korea, 184
sovereign risks, 123, 126
specie-flow-price mechanism, 180
speculation, 13, 107, 113, 130,131,171,
173,174,176,178,181,182
Steady Safe, 123
sterling crisis, 207
Stem, Paul c., 35, 212
Stiglitz, Joseph, 115, 129, 132,217
stock market crash, 99, 119, 126, 176,
177, 178, 179, 207
substantive democracy, 2, 135
substantive goods, 19,21,25,27, 34
success, 4, 12,22,25,46,51,54, 72, 75,
99,109,112,114,119,121,141,
145, 146, 156, 196, 197,203,208
Summers, Lawrence, 118
supply-side moral hazard, 62, 64, 72, 73
sweatshops, 202
Sweden, 65, 68, 95
systems perspective, 15, 144
Tenant Purchase Scheme, 132, 155, 186,
189,194,195
Thatcher, Margaret, 139
theory of surplus value, 46
Tittenbrun, Jacek, 139, 140,217
transparency, 99,107, 129, 130, 131, 132
true utility function, 20, 22, 24, 25, 26, 27,
29,30,35
unemployment insurance, 10, 168, 170
unemployment loans, 168
universal access principle, 66
universal fully funded pension, 89, 90, 91,
92,93,96
universal wage subsidy, 165, 166, 170
universality, 66, 75, 76, 205, 206
user pays principle, 80, 139
utilitarian utility, 22, 23, 26, 27
valorization accounts, 103
valun, 122
vicious circle, 30, 112
Vishny, Robert W., 203, 217
Volcker, Paul, 15, 112
von Neumann-Morgenstern, 28
wage subsidy, 164, 166, 167, 169
223
Index
Walton, GaryM., 178, 182,217
World Currency Unit (WCU), x, 122, 124,
132,202,214
Wray, L. Randall, 205, 216

Yugoslavia, 102
Zwiebel, Jeffrey, 137,215

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PRINCIPLES OF PUBLIC POLICY PRACTICE

ABOUT THE AUTHOR

SPRINGER SCIENCE+BUSINESS MEDIA, LLC

Library of Congress Cataloging-in-Publication Data

Copyright 2001 by Springer Science+Business Media New York

Printed on acid-free paper.

To Alvin, Emily, and Irene

The Theory of Public Policy Design

Microeconomic Risk Management

Resource Allocation and Redistribution

It is a pleasure to read this well-written book and an honor to write the

While corporal punishment may also impose damage on family members,

even at a cost of lowering one's own happiness. (See Ng 2000, ChA.)

I would like to thank, in particular, Prof. Yew-Kwang Ng of Monash

1. DEMOCRATIC INSTITUTIONS, "SUBSTANTIVE

Principles of Public Policy Practice

predatory behaviour by the state. They are neither a necessary nor a

My second contention is that the modern day democratic process is

Principles ofPublic Policy Practice

2. THE CENTRAL FOCUS OF THIS BOOK

Principles of Public Policy Practice

implications about risk. Third is theories about public choice mechanisms.

THE THEORY OF PUBLIC POLICY DESIGN

The design of public policy must take full consideration of human

Principles ofPublic Policy Practice

2. THE CONSTRAINT OF HUMAN NATURE

What Makes Good Public Policy

Principles of Public Policy Practice

3. THE HIERARCHY OF POLICY GOALS

What Makes Good Public Policy

longer tenn objectives as constraints. Thus a policy aimed at providing

4. COSTS, BENEFITS, AND OPTIMALITY

Principles of Public Policy Practice

will, however, increase the chance of acquitting a culprit, which is a cost.

Take the example of the mandatory private provident fund (MPPF)

What Makes Good Public Policy

Principles ofPublic Policy Practice

The Dimensions of Optimality

What Makes Good Public Policy

of training and in-service teachers the optimal amount of continuous training?

The Ex Ante Welfare Maximization Paradigm

Principles ofPublic Policy Practice

Human nature is a vast subject. For the purpose of policy analysis

Principles of Public Policy Practice

normative connotations. Achieving a higher value of the objective function

Human Nature and Public Policy

problems arising from household production. They proposed an iterative

2. A MODEL OF HUMAN NATURE

Principles ofPublic Policy Practice

Proposition 2: Diversity of Perceptions

Human Nature and Public Policy

Definition: Happiness vs. Utilitarian Utility

We assume that the overall state of well-being for any representative

Because of the inherent impossibility of making decisions ahead of

Principles of Public Policy Practice

utilitylhappiness function subject to a known life-time opportunity set.

Definition: Life Skills

Proposition 4: Maximization ofPerceived Utility

Human Nature and Public Policy

coincide with true constraints}. This he does by pursuing various activities.

Just as there is a true utility function along the perceived utility

Principles of Public Policy Practice

while some pleasurable experience may make him overlook the